Notes on Exchange Rate Theories: PPP and IRP

THE PURCHASING POWER PARITY (PPP)

• Definition: The Purchasing Power Parity theory posits that the exchange rate between two countries is based on the relative purchasing power of their currencies.
• Origin: Proposed by Professor Gustav Cassel.
• Key Principle: Exchange rates will adjust to equate the purchasing power of different currencies.
• Example of PPP:
  • If £1 in Britain buys the same goods as Rs. 80 in India, then according to PPP, the exchange rate should be:
  • $1 ext{ GBP} = 80 ext{ INR}$
  • Similarly, if $1 in the USA buys the same goods as Rs. 60 in India, then:
  • $1 ext{ USD} = 60 ext{ INR}$

IMPACT OF PRICE CHANGES ON PPP

• If prices in India double while remaining unchanged in the USA:
  • The new exchange rate parity would be:
  • $1 ext{ USD} = 120 ext{ INR}$
• If prices in both countries double, there would be no change in parity.
• Practical Considerations: Actual exchange rates may differ due to transportation costs and tariffs.

CRITICISMS OF PPP THEORY

• Actual exchange rates often do not reflect purchasing power due to government interventions in price controls and exchange rates.
• Limited Applicability: PPP pertains mainly to goods involved in international trade, ignoring domestic goods not subject to international pricing.
• Difficulty of Measurement: Index numbers used to assess purchasing power have limitations such as varied goods included and disparities in local prices versus international prices.
• Dynamic World: The economy is in constant flux, which affects stable conclusions on exchange rates due to shifts in internal prices and production costs.
• Omissions: The theory doesn’t consider the influences of tariffs, customs, and capital movements on currency value.
• Keynes' Critique:
  • Ignores elasticity of reciprocal demand and the effects of capital movements on exchange rate determination.

INTEREST RATE PARITY (IRP)

• Definition: The theory that the difference between interest rates of two countries equals the difference implied by the forward and spot exchange rates.
• Significance: Crucial in Forex markets for connecting interest rates and exchange rates.

TYPES OF INTEREST RATE PARITY

• Covered Interest Rate Parity (CIRP): Prevents arbitrage by ensuring that forward premiums/discounts nullify interest rate differentials.
  • Example: If Yahoo Inc. wishes to pay European employees in Euros, it can lock in an exchange rate by buying Euros forward, eliminating exchange rate risk.
• Uncovered Interest Rate Parity (UIP): Indicates that expected currency appreciation (depreciation) is offset by interest rate differentials, with an outcome tied to currency exchange risk.

IMPLICATIONS OF IRP

• When IRP holds, arbitrage opportunities are negated, ensuring identical returns on investments regardless of currency choice.
• If domestic interest rates are below foreign rates, the foreign currency should trade at a forward discount.
• If domestic rates exceed foreign rates, the foreign currency must trade at a forward premium, preventing arbitrage for domestic investors.

EXAMPLES AND APPLICATIONS

• Case Study: Investing €1000 in the US:
  • Home Investment:
  • Spot exchange rate = $1.2245/€
  • Investment at 3% yields:
    • $€1000 imes 1.03 = 1224.50 ext{ USD}$ to $1261.79 ext{ USD}$ after 1 year.
  • International Investment:
  • Rate at 5% yields:
    • $€1000 imes 1.05 = 1051.27 €$
    • Convert at forward rate ($1.20025) gives $1261.79 ext{ USD}$.
• Conclusion: Both investments yield the same return, showing adherence to IRP.

CONCLUSION

• The theories of Purchasing Power Parity and Interest Rate Parity are foundational to understanding exchange rates and provide frameworks for economic analysis and financial decision-making in a global context.