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Dilfraz Singh, Lovely Professional University Unit 15 : Theories of Determination of Exchange Rate (PPP, Monetary)

Unit 15 : Theories of Determination of Exchange Rate Notes
(PPP, Monetary)

CONTENTS
Objectives
Introduction
15.1 The Purchasing Power Parity Theory
15.2 Monetary Models of Exchange Rate Determination
15.3 Summary
15.4 Key-Words
15.5 Review Questions
15.6 Further Readings

Objectives

After reading this Unit students will be able to:
• Discuss the Purchasing Power Parity Theory.
• Explain the Monetary Models of Exchange Rate Determination.

Introduction

Many theories there have been written in respect to the main determinant of future exchange rates.
Although the majority of these theories give adequate reasons in order to explain what actually
determines the rates between the currencies, we can argue that there are many factors that may cause
a currency fluctuation. Consequently, there is little that can be alleged in respect to the theory that
better answers the question of what finally determines the exchange rates.
Here below, we will refer to the main theories regarding the determinants of the exchange rates.
15.1 The Purchasing Power Parity Theory

The purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920 to determine the
exchange rate between countries on inconvertible paper currencies. The theory states that equilibrium
exchange rate between two inconvertible paper currencies is determined by the equality of their
purchasing power. In other words, the rate of exchange between two countries is determined by their
relative price levels. The theory can be explained with the help of an example.
Suppose India and England are on inconvertible paper standard and by spending Rs. 60, the same
bundle of goods can be purchased in India as can be bought by spending £ 1 in England. Thus
according to the purchasing power parity theory, the rate of exchange will be Rs. 60 = £ 1.
If the price levels in the two countries remain the same but the exchange rate moves to Rs. 50 = £ 1.
This means that less rupees are required to buy the same bundle of goods in India as compared to £ 1
in England. It is a case of overvaluation of the exchange rate. This will encourage imports and discourage
exports by India. As a result, the demand for pounds will increase and that of rupees will fall. This
process will ultimately restore the normal exchange rate of Rs. 60 = £ 1. In the converse case, if the
exchange rate moves to Rs. 70 = £ 1, the Indian currency become undervalued. As a result, exports are
encouraged and imports are discouraged. The demand for rupees will rise and that for pounds will
fall so that the normal exchange rate of Rs. 60 = £ 1 will be restored.

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