Page 76 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 5: Currency Forecasting

forecasters were not correct and also that the mechanics of exchange rate determination needs to Notes
studied thoroughly.

The tremendous increase in international mobility of capital as a result of marked improvements
in telecommunications all over and also lesser restrictions on international financial transactions
has made the concept of exchange rate determination more complicated and difficult to
understand. The above factors have often resulted in the forex market behaving like a volatile
stock market. In fact, economists now have been forced to reverse their thinking about exchange
rate determination.
Thus, while much remains to be learned about exchange rates, a lot is also understood about
them. Exchange rates forecasts have often been wrong, though many times they have also met
with impressive success. Also, when exchange rate determination has been matched against
historical records, it has had much explanatory power.
Are changes in exchange rates predictable? How does inflation affect exchange rates? How are
interest rate related to exchange rates? What is the ‘proper exchange rate’ in theory? For an
answer to these fundamental issues, it is essential to understand the different theories of exchange
rate determination.
The three theories of exchange rate determination are:
1. Purchasing Power Parity (PPP), which links spot exchange rates to nations’ price levels.

2. The Interest Rate Parity (IRP).
3. The International Fisher Effect (IFE) which links exchange rates to nations’ nominal interest
rate levels.

5.1 Purchasing Power Parity (PPP)

The PPP theory focuses on the inflation-exchange rate relationships. If the law of one price were
true for all goods and services, we could obtain the theory of PPP. There are two forms of the PPP
theory.

5.1.1 Absolute Purchasing Power Parity

The absolute PPP theory postulates that the equilibrium exchange rate between currencies of
two countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar
products of two different countries should be equal when measured in a common currency as
per the absolute version of PPP theory.

A Swedish economist, Gustav Cassel, popularised the PPP in the 1920s. When many countries
like Germany, Hungary and Soviet Union experienced hyperinflation in those years, the
purchasing power of the currencies in these countries sharply declined. The same currencies also
depreciated sharply against the stable currencies like the US dollar. The PPP theory became
popular against this historical backdrop.
Let P refer to the general price level in nation A, P the general price level in nation B and R to
a b ab
the exchange rate between the currency of nation A and currency of nation B. Then the absolute
purchasing power parity theory postulates that
R = P /P
ab a b
For example, if nation A is the US and nation B is the UK, the exchange rate between the dollar
and the pound is equal to the ratio of US to UK Prices. For example, if the general price level in

LOVELY PROFESSIONAL UNIVERSITY 71