# Theories of Foreign Exchange Rate Determination

25/08/2020

The theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other. In other words, the expenditure on a similar commodity must be same in both currencies when accounted for exchange rate. The purchasing power of each currency is determined in the process.

Purchasing power parity is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country.

Example: Let’s say that a pair of shoes costs Rs 2500 in India. Then it should cost \$50 in America when the exchange rate is 50 between the dollar and the rupee.

Purchasing power parity theory is based on a market-basket approach to comparing the cost of living between two or more countries. The concept is simple in principle: Compare how much consumers pay for the same types of items in their own currency and use the comparative information to determine the relative costs of living for the economies in question.

For example, suppose a computer costs \$1,000 in the United States, and the very same computer can be purchased for £900 in England. The exchange rate between these two currencies is easy to look up: In October 2019, 1 British pound was equivalent to \$1.28 in U.S. currency.

In other words, the £900 computer would cost, in dollars, 900 x 1.28, or \$1,152. In this (entirely hypothetical) example, a consumer in England is paying about 15 percent more than a consumer in the U.S. for the same item. If that is true across the board for other goods, then the cost of living in England, or its PPP, is 15 percent greater than in the U.S.

Purchasing Power Parity Theory in Practice

While the concept behind purchasing power parity may be straightforward, in practice, it’s difficult to come up with realistic comparisons. The key issue is the wide variability in products and services available in different countries. The computers sold in Britain and in the U.S., though similar, may not be exactly the same – and even if they are, they may not come bundled with the same software, subscriptions, technical assistance packages and so on.

Comparing housing costs from one country to another can also be challenging, especially when lifestyles may differ significantly. An apartment dweller in New York City has a very different living experience than, say, a reindeer herder in Lapland or a villager in rural Nigeria.

To get around these difficulties with PPP theory, international organizations like the United Nations and the World Bank have attempted to standardize market-basket comparisons, making whatever adjustments are needed to account for local differences.

#### Purchasing Power Parity Theory and GDP

National economies are compared using a metric known as the gross domestic product, or GDP. This measures the value of all the goods and services produced in a country during a year. The size of countries’ economies can be ranked by comparing the size of the GDP of each nation. But it’s not as simple as it sounds.

The key issue, once again, revolves around comparing currencies. The GDP of the United States is measured in dollars; Britain’s, in pounds; China’s in yuan; Japan’s in yen; Germany, France and other EU members’ in Euros; and so on. Before they can be compared, the GDPs need to be converted to a common unit of currency. In international circles, the conversion is usually expressed as dollars.

If the official exchange rates (say, between the U.S. dollar and the Chinese yuan) are used for the conversion, then the ranking of the top five economies in the world (in 2018-2019) looks like this:

• India
• United States
• China
• Japan
• Germany

However, if the PPP of each currency is used to determine conversion rates, as suggested by purchasing PPP theory, then the list takes on a different look:

• China
• United States
• India
• Japan
• Germany

These differences reflect differences in the cost of living in the countries, as indicated in the PPP market-basket calculations. China and India, generally have lower costs of living, so the money circulating in the economies of these countries goes farther, so to speak, than an equivalent amount of cash would go in the economies of the U.S., Germany and Japan.

#### Interest Rate Theories

Interest rate theories use the inflation rates in determining the exchange rates, unlike the price levels used under the PPP theory.

#### Fisher Effect theory

Establishing a relationship between the inflation and interest rates, the Fisher Effect (FE) theory states that the nominal interest rate ‘r’ in a country is determined by the real interest rate ‘R’ and the expected inflation rate ‘i’ as follows

(1 + Nominal interest rate) = (1 + Real interest rate)

(1 + Expected inflation rate)

(l + r) = (l + R)( 1 + i)

or r = R + i + Ri

Since, Ri is of negligible value, the preceding equation is generally approximated as

r = R + i

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate is used to assess exchange rate movements as it includes interest and inflation rates, both of which affect exchange rates. Given all other parameters constant, there is a high co-relation between differentials in real interest rate and the exchange rate of a currency.

#### International Fisher Effect theory

The International Fisher Effect (IFE) combines the PPP and the FE to determine the impact of relative changes in nominal interest rates among countries on their foreign exchange values. According to the PPP theory, the exchange rates will move to offset changes in inflation rate differentials.

Thus, a rise in a country’s inflation rate relative to other countries will be associated with a fall in its currency’s exchange value. It would also be associated with a rise in the country’s interest rate relative to foreign interest rates. A combination of these two conditions is known as the IFE, which states that the exchange rate movements are caused by interest rate differentials.

If real interest rates are the same across the country, any difference in nominal interest rates could be attributed to differences in expected inflation. Foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation.

The IFE explains that the interest rate differential between any two countries is an unbiased predictor of the future changes in the spot rate of exchange.

Other Determinants of Exchange Rates

In addition to inflation, real income, and interest rates, other market fundamentals that influence the exchange rates include bilateral trade relationships, customer tastes, investment profitability, product availability, productivity changes, and trade policies.