Exchange rates and Theory

Exchange Rates

The demand and supply of a currency influences the exchange rates. The changes in demand and supply of a currency are due to:

  1. Balance of payments (The level of demand for Imports/Exports)
  2. Purchasing power parity theory (PPPT)
  3. Interest rate parity theory (IRPT)
  4. Four-way equivalence (Combination of all the above models)

Note that the purchasing power parity, interest rate parity and the fisher effect are theories used to predict the movement of exchange rates.

Purchasing power parity theory

The purchasing power parity theory is ‘the law of one price’ and refers to how goods should cost the same regardless of the currency they are sold in. The PPPT predicts that the country with high inflation experiences a decrease in currency value. The model is used to predict future exchange/interest rates, also known as spot rates.

The issue with this model includes:

  • Inflation rates are only estimates
  • Government can intervene to manage exchange rates

Interest rate parity theory

The Interest rate parity analyses the relation between spot rates and forward rates. This model is concerned with the foreign exchange market and the international money market. It enables the prediction of the future exchange rates.

Fisher Effect

The international fisher effect assumes that the higher the interest rate of a country the more the currency depreciates in value. So countries with low interest rates will have a stronger currency compared to those with high interest rates.