4.1 Theories of exchange rate determination

Exchange rates play a crucial role in international finance. Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are two key theories explaining how they're determined. PPP focuses on price levels, while IRP considers interest rate differences between countries.

The Monetary Approach combines elements of both PPP and IRP. It emphasizes the impact of money supply and demand on exchange rates. Understanding these theories helps predict currency movements and informs financial decision-making in global markets.

Purchasing Power Parity and Interest Rate Parity

Principles of purchasing power parity

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• Law of One Price underpins PPP stating identical goods should have same price across countries when expressed in same currency (Big Mac Index)
• Absolute PPP posits exchange rates adjust to equalize purchasing power of different currencies
• Relative PPP focuses on changes in exchange rates reflecting differences in inflation rates between countries
• Assumes no transportation costs, trade barriers, perfectly competitive markets, homogeneous goods across countries
• PPP equation: $E = P_{domestic} / P_{foreign}$ where E is exchange rate and P is price level
• Real-world limitations due to non-tradable goods, quality differences, and market imperfections

Interest rate parity theory

• Covered Interest Rate Parity (CIRP) represents no-arbitrage condition in forex markets
• Forward exchange rate determined by interest rate differentials under CIRP
• Uncovered Interest Rate Parity (UIRP) states expected future spot rate determined by interest rate differentials
• IRP equation: $(1 + i_{domestic}) = (1 + i_{foreign}) * (F / S)$ where i is interest rate, F is forward rate, S is spot rate
• Higher interest rates generally lead to currency appreciation, lower rates to depreciation
• Interest rate differentials drive capital flows between countries (carry trade)
• Assumes perfect capital mobility and risk neutrality

Monetary Approach and Theory Comparison

Monetary approach to exchange rates

• Emphasizes money supply, money demand, and price levels in determining exchange rates
• Assumes flexible prices, full employment, perfect capital mobility
• Relative money supply changes affect exchange rates directly
• Increase in domestic money supply typically leads to currency depreciation
• Monetary model equation: $e = (m - m*) - (y - y*) + (v - v*)$ where e is exchange rate, m is money supply, y is real income, v is velocity of money, * denotes foreign variables
• Incorporates both PPP and IRP principles in a unified framework

Comparison of exchange rate theories

• PPP focuses on goods market equilibrium, applicable long-term (GDP comparisons)
• IRP emphasizes financial market equilibrium, useful short-term (forex trading)
• Monetary approach combines PPP and IRP elements, medium to long-term applicability (policy analysis)
• PPP useful for long-term forecasting and comparing living standards across countries
• IRP valuable for short-term exchange rate predictions and currency trading strategies
• Monetary approach helps explain currency movements in response to monetary policy changes (quantitative easing)
• PPP ignores capital flows and non-tradable goods, IRP assumes perfect capital mobility
• Monetary approach may oversimplify complex economic relationships
• Combining theories provides comprehensive understanding of currency movements
• Each theory offers insights into different aspects of exchange rate determination