Page 187 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

rises in India and remains constant in England. This makes Indian exports costly in England Notes
and imports from England relatively cheaper in India. As a result, the demand for pounds
increases and the supply of pounds decreases. Now the DD curve shifts upward to the right to
D D and the SS curve to the left to S S . The new equilibrium exchange rate is set at OR rupees
1
1
1 1
1
per pound, which represents the new purchasing power parity. The exchange rate rises by the
same percentage as the India price level.
• Aside from its theoretical usefulness, however, the assumption that economic agents use their
knowledge of the (fixed) stochastic process generating the money supply as the primary
ingredient in forming the expectations necessary for determining the exchange rate is not likely
to provide a fully adequate empirical explanation of actual exchange rate movements.
15.4 Key-Words

1. Depreciation : A noncash expense that reduces the value of an asset as a result of wear and tear,
age, or obsolescence. Most assets lose their value over time (in other words, they
depreciate), and must be replaced once the end of their useful life is reached.
There are several accounting methods that are used in order to write off an asset's
depreciation cost over the period of its useful life. Because it is a non-cash expense,
depreciation lowers the company's reported earnings while increasing free cash
flow.
2. Appreciation : An increase in the value of an asset over time. The increase can occur for a number
of reasons including increased demand or weakening supply, or as a result of
changes in inflation or interest rates. This is the opposite of depreciation, which
is a decrease over time
15.5 Review Questions

1. What is the purchasing power parity theory? Discuss.
2. Determine the monetary models of exchange rate.
Answers: Self-Assessment

1. (i)(c) (ii)(b) (iii)(d) (iv)(d)
15.6 Further Readings

1. Bilson, John F.O., 1981, The speculative efficiency hypothesis. Journal of Business
54, July, 435–451.
2. Breeden, Douglas T., 1979, An intertemporal asset pricing model with stochastic
consumption and investment opportunities, Journal of Financial Economics 7,
Sept., 265–296.
3. Domowitz, Ian and Craig S. Hakkio, 1983, Conditional variance and the risk
premium on the foreign exchange market, Manescript, Sept.
4. Fama, Eugene F. 1982, Inflation, output and money, Journal of Business 55, April,
201–231.

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