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What happens if the currency of a country is allowed to float?
Then the exchange rate against other currencies will fluctuate
What factors affect the exchange rate?
The supply and demand for the currencies
What affects the demand and supply for the currencies?
Inflation rates in the two countries
Interest rates in the two countries
Economic and political prospects
The balance of payments
What is purchasing power parity?
The purchasing power parity theory uses inflation rates to predict the future movements in exchange rates
It states that identical goods should sell at the same price when converted into the same currency
As the local currency prices change with inflation, then the exchange rates should change to keep the relative price the same
What is the fisher effect?
The fisher effect looks at the relationship between interest rates and expected inflation rates
The actual interest rate will therefore increase or decrease with increases or decreases in the inflation rate
What is the Interest rate parity?
Uses relative interest rates to predict the future exchange rate
What is the Purchasing power parity formula?
S1 = S0 x (1 + hc)/(1 + hb)
What is the interest rate parity formula?
Same as the PPP formula but uses interest rates instead of inflation rates.
