Purchasing Power Parity Theory of Foreign Exchange Rate!

No country today is rich enough to have a free gold standard, not even the U.S.A. All countries have now paper
currencies and these paper currencies of the various countries are not convertible into gold or other valuable
things. Therefore, these days various countries have paper currency standards. The exchange situation is
difficult in such cases. In such circumstances the ratio of exchange between the two currencies is determined by
their respective purchasing powers.
The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to this
theory, rate of exchange between two countries depends upon the relative purchasing power of their respective
currencies.

Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods
can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the purchasing
power of £1 is equal to the purchasing power of Rs. 80. Thus, the rate of exchange, according to purchasing
power parity theory, will be £1 =Rs. 80.
Let us take another example. Suppose in the USA one $ purchases a given collection of commodities. In India,
same collection of goods cost 45 rupees.
Then rate of exchange will tend to be:
$1=45 rupees. Now, suppose the price levels in the two countries remain the same but somehow exchange rate
moves to $1 =46 rupees.
This means that one US$ can purchase commodities worth more than 45 rupees. It will pay people to convert
dollars into rupees at the rate ($1 = Rs. 46), purchase the given collection of commodities in India for 45 rupees
and sell them in U.S.A. for one dollar again, making a profit of 1 rupee per dollar worth of transactions.
This will create a large demand for rupees in the USA while supply thereof will be less because very few people
would export commodities from USA to India. The value of the rupee in terms of the dollar will move up until it
will reach $1 = 45 rupees. At that point, imports from India will not give abnormal profits. $ 1 = 45 rupees is
called the purchasing power parity between the two countries.

Thus while the value of the unit of one currency in terms of another currency is determined at any particular
time by the market conditions of demand and supply, in the long run the exchange rate is determined by the
relative values of the two currencies as indicated by their respective purchasing powers over goods and services.
In other words, the rate of exchange tends to rest at the point which expresses equality between the respective
purchasing powers of the two currencies. This point is called the purchasing power parity.
Thus, under a system of autonomous paper standards the external value of a currency is said to depend
ultimately on the domestic purchasing power of that currency relative to that of another currency. In other
words, exchange rates, under such a system, tend to be determined by the relative purchasing power parities of
different currencies in different countries.
In the above example, if prices in India get doubled, the value of the rupee will be exactly halved. The new
parity will be $1 = 90 rupees. This is because now 90 rupees will buy the same collection of commodities in
India which 45 rupees did before. We suppose that prices in USA remain as before. But if prices in both
countries get doubled, there will be no change in the parity.
In actual practice, however, the parity will be modified by the cost of transporting goods (including duties etc.)
from one country to another.
Criticism of Purchasing Power Parity Theory:
The purchasing power parity theory has been subject to the following criticisms:
The actual rates of exchange between the two countries very seldom reflect the relative purchasing powers of
the two currencies. This may be due to the fact that governments have either controlled prices or controlled
exchange rates or imposed restrictions on import and export of goods.

Moreover, the theory is true if we consider the purchasing power of the respective currencies in terms of goods
which enter into international trade and not the purchasing power of goods in general. But we know that all
articles produced in a country do not figure in international trade.
Therefore, the rate of exchange cannot reflect the purchasing power of goods in general. For example, in India
we may be able to get a dozen shirts washed with Rs. 40, but only 2 shirts with one dollar in the USA.
Obviously, the purchasing power of one dollar in the USA is much less than the purchasing power of Rs. 40 in
India.
This is due to the fact that dhobis do not form an article of international trade. If dhobis entered into
international trade and freely moved into the U.S.A., then in terms of clothes washed, the purchasing power of
Rs. 40 may be equalised with the purchasing power of a dollar.
Further, it is very difficult to measure purchasing power of a currency. It is usually done with the help of index
numbers. But we know that the index numbers are not infallible.
Among the difficulties connected with index numbers are the following important ones:
(i) Different types of goods that enter into the calculation of index numbers;
(ii) Many goods which may enter into domestic trade may not figure in international trade;
(iii) Internationally traded goods also may not have the same prices in all the markets because of differences in
transport costs.
Besides, the theory of purchasing power applies to a stationary world. Actually the world is not static but
dynamic. Conditions relating to money and prices, tariffs, etc., constantly go on changing and prevent us from
arriving at any stable conclusion about the rates of exchange. The internal prices and the cost of production are
constantly changing. Therefore, a new equilibrium between the two currencies is almost daily called for.
As Cassel observes, “differences in two countries’ economic situation, particularly in regard to transport and
customs, may cause the normal exchange rate to deviate to a certain extent from the quotient of the currencies
intrinsic purchasing powers.” If a country raises its tariffs, the exchange value of its currency will rise but its
price level will remain the same.
Besides, many items of balance of payments like insurance and banking transactions and capital movements are
very little affected by changes in general price levels. But these items do influence exchange rates by acting
upon the supply of and the demand for foreign currencies.
The Purchasing Power Parity Theory ignores these influences altogether. Further, the theory, as propounded by
Cassel, says that changes in price level bring about changes in exchange rates but changes in exchange rates do
not cause any change in prices. This latter part is not true, for exchange movements do exercise some influence
on internal prices.
The purchasing power parity theory compares the general price levels in two countries without making any
provision for distinction being drawn between the price level of domestic goods and that of the internationally
traded goods.
The prices of internationally-traded goods will tend to be the same in all countries (transport costs are, of course
omitted). Domestic prices on the other hand, will be different in the two countries, even between two areas of
the same country.

The purchasing power parity theory assumes that there is a direct link between the purchasing power of
currencies and the rate of exchange. But in fact there is no direct relation between the two. Exchange rate can be
influenced by many other considerations such as tariffs, speculation and capital movements.
According to Keynes, there are two basic defects in the purchasing power parity theory, viz.:
(i) It does not take into consideration the elasticity’s of reciprocal demand, and
(ii) It ignores the influences of capital movements.

In Keynes’s view, foreign exchange rates are determined not only by the price movements but also by capital
movements, the elasticity’s of reciprocal demand and many other forces affecting the demand for and supply of
foreign exchange. “By elasticity of reciprocal demand is meant the responsiveness of one country’s demand for
another country’s exports with respect to price or income.”
As for price elasticity, generally speaking, greater the proportion of luxuries and semi-luxuries in the exports
demanded, the more elastic will be the country’s demand for another country’s exports. It will also be more
elastic, when there is a greater number of alternative markets in which to buy and greater the capacity to
produce the effective substitutes for goods imported.
As for the income elasticity of demand for imports, changes in demand for goods and services and in the
derived demand for foreign exchange is functionally related to the changes in national income. How far is a
country’s demand for another’s exports responsive to a change in national income, will influence the rate of
exchange.
In other words, it is the character of the propensity to import out of a given income that is, supposed to affect
the exchange rate independently of international price movements. Technological improvement adding to the
productivity of the country and making its goods cheaper and better, tariff changes and exports subsidies affect
exchange rates via their influence upon reciprocal demand quite independently of international price move-
ments.
Capital movements, both short-term and long-term, are the other important influences. There is hot money
flying from a country trying to make profits or avoid loss on exchange fluctuations and there is a ‘refugee
capital’ seeking safely and security abroad.
An actual or expected change in the domestic price of a foreign currency may lead to inflow or outflow of ‘hot
money’ causing a further change in the exchange rate without there being price changes in either country. The
inflow tends to raise the exchange value of the currency of the capital receiving country and outflow will lower
it. Long-term movement of capital also has a similar effect.
In view of the defects pointed out above the purchasing power parity theory does not offer an adequate or
satisfactory explanation of fluctuations in the rates of exchange. The determination of the exchange rate
depends not only on international price relations but on many other factors as mentioned above.
This leads to a more adequate explanation of the determination of foreign exchange rates through demand for
and supply of foreign exchange viz. balance of payments theory. This theory has been explained above.
What is Interest Rate Parity?
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of two
countries remains equal to the differential calculated by using the forward exchange rate and
the spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and
foreign exchange rates. It plays a crucial role in Forex markets.
IRP theory comes handy in analyzing the relationship between the spot rate and a relevant
forward (future) rate of currencies. According to this theory, there will be no arbitrage in
interest rate differentials between two different currencies and the differential will be reflected
in the discount or premium for the forward exchange rate on the foreign exchange.
The theory also stresses on the fact that the size of the forward premium or discount on a
foreign currency is equal to the difference between the spot and forward interest rates of the
countries in comparison.
Example
Let us consider investing € 1000 for 1 year. As shown in the figure below, we'll have two
options as investment cases −
Case I: Home Investment
In the US, let the spot exchange rate be $1.2245 / €1.
So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50
We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the
end of the year.
Case II: International Investment
We can also invest €1000 in an international market, where the rate of interest is 5.0% for 1
year. So, €1000 @ of 5% for 1 year = €1051.27
Let the forward exchange rate be $1.20025 / €1.
So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to convert
our €1000 back to the domestic currency, i.e., the U.S. Dollar.
Then, we can convert € 1051.27 @ $1.20025 = $1261.79

Thus, when there is no arbitrage, the Return on Investment (ROI) is equal in both cases,
regardless the choice of investment method.
Arbitrage is the activity of purchasing shares or currency in one financial market and selling it
at a premium (profit) in another.

Covered Interest Rate Parity (CIRP)

According to Covered Interest Rate theory, the exchange rate forward premiums (discounts)
nullify the interest rate differentials between two sovereigns. In other words, covered interest
rate theory says that the difference between interest rates in two countries is nullified by the
spot/forward currency premiums so that the investors could not earn an arbitrage profit.

Example
Assume Yahoo Inc., the U.S. based multinational, has to pay the European employees in Euro
in a month's time. Yahoo Inc. can do this in many ways, one of which is given below −
 Yahoo can buy Euro forward a month (30 days) to lock in the exchange rate. Then it can
invest this money in dollars for 30 days after which it must convert the dollars to Euro.
This is known as covering, as now Yahoo Inc. will have no exchange rate fluctuation
risk.
 Yahoo can also convert the dollars to Euro now at the spot exchange rate. Then it can
invest the Euro money it has obtained in a European bond (in Euro) for 1 month (which
will have an equivalently loan of Euro for 30 days). Then Yahoo can pay the obligation
in Euro after one month.
Under this model, if Yahoo Inc. is sure that it will earn an interest, it may convert fewer dollars
to Euro today. The reason for this being the Euro’s growth via interest earned. It is also known
as covering because by converting the dollars to Euro at the spot rate, Yahoo is eliminating the
risk of exchange rate fluctuation.
Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory says that the expected appreciation (or depreciation) of a
particular currency is nullified by lower (or higher) interest.

Example
In the given example of covered interest rate, the other method that Yahoo Inc. can implement
is to invest the money in dollars and change it for Euro at the time of payment after one month.
This method is known as uncovered, as the risk of exchange rate fluctuation is imminent in
such transactions.

Covered Interest Rate and Uncovered Interest Rate

Contemporary empirical analysts confirm that the uncovered interest rate parity theory is not
prevalent. However, the violations are not as huge as previously contemplated. The violations
are in the currency domain rather than being time horizon dependent.
In contrast, the covered interest rate parity is an accepted theory in recent times amongst the
OECD economies, mainly for short-term investments. The apparent deviations incurred in such
models are actually credited to the transaction costs.

Implications of IRP Theory

If IRP theory holds, then it can negate the possibility of arbitrage. It means that even if
investors invest in domestic or foreign currency, the ROI will be the same as if the investor had
originally invested in the domestic currency.
 When domestic interest rate is below foreign interest rates, the foreign currency must
trade at a forward discount. This is applicable for prevention of foreign currency
arbitrage.
 If a foreign currency does not have a forward discount or when the forward discount is
not large enough to offset the interest rate advantage, arbitrage opportunity is available
for the domestic investors. So, domestic investors can sometimes benefit from foreign
investment.
 When domestic rates exceed foreign interest rates, the foreign currency must trade at a
forward premium. This is again to offset prevention of domestic country arbitrage.
 When the foreign currency does not have a forward premium or when the forward
premium is not large enough to nullify the domestic country advantage, an arbitrage
opportunity will be available for the foreign investors. So, the foreign investors can gain
profit by investing in the domestic market.

Interest Rate Parity

Interest rate parity is a theory proposing a relationship between the interest rates of two given
currencies and the spot and forward exchange rates between the currencies. It can be used to
predict the movement of exchange rates between two currencies when the risk-free interest rates
of the two currencies are known.
Interest rate parity theory assumes that differences in interest rates between two currencies
induce readjustment of exchange rate. However, exchange rates are determined by several other
factors and not just the interest rate differences, therefore interest rate parity theory cannot
predict or explain all movements in exchange rates. But it does serve as a useful guide
nonetheless.
Interest rate parity theory is based on assumption that no arbitrage opportunities exist in foreign
exchange markets meaning that investors will be indifferent between varying rate of returns on
deposits in different currencies because any excess return on deposits in a given currency will
be offset by devaluation of that currency and any reduced return on deposits in another currency
will be offset by appreciation of that currency.
Covered interest rate parity exists when forward contract rates of currencies can be used to
prove that no arbitrage opportunities exist. If forward exchange quotes are not available the
interst rate parity exists but it is called uncovered interst rate parity.
Formula
Covered interest rate parity may be presented mathematically as follows:
n
Forward Rate 1 + iquot
=
Spot Rate 1 + ibase
Where,
iquot is the interest free rate of return on deposits of quote currency,
ibase is that rate for base currency and
n are the number of years until the date of forward rate.
If exchange rate is quoted as USD/EUR i.e. Euros per 1 US Dollar, the USD is the base
currency and EUR is the quote currency.
Interest rate parity can be used to estimate forward rates between two currencies by rearranging the above
equation to:
n
1 + iquot
Forward Rate = Spot Rate ×
1 + ibase
Example
Suppose mid-market USD/CAD spot exchange rate is 1.2500 CAD and one year forward rate is
1.2380 CAD. Also the risk-free interest rate is 4% for USD and 3% for CAD. Check whether
interest rate parity exist between USD and CAD?
Solution:
Ratio of Forward to Spot
= 1.2380 ÷ 1.2500
= 0.9904
Ratio of Returns
= [(1+3%) ÷ (1+4%)]^1
≈ 0.9904
Since the two values are approximately equal, therefore interest rate parity exists.
THE BASICS OF THE FISHER EFFECT

Fisher's equation reflects that the real interest rate can be taken by subtracting the expected
inflation rate from the nominal interest rate. In this equation, all the provided rates are
compounded.
The Fisher Effect can be seen each time you go to the bank; the interest rate an investor has on a
savings account is really the nominal interest rate. For example, if the nominal interest rate on a
savings account is 4% and the expected rate of inflation is 3%, then the money in the savings
account is really growing at 1%. The smaller the real interest rate, the longer it will take for
savings deposits to grow substantially when observed from a purchasing power perspective.
KEY TAKEAWAYS
 The Fisher Effect is an economic theory created by economist Irving Fisher that describes
the relationship between inflation and both real and nominal interest rates.
 The Fisher Effect states that the real interest rate equals the nominal interest rate minus
the expected inflation rate.
 The Fisher Effect has been extended to the analysis of the money supply and international
currencies trading.

Nominal Interest Rates and Real Interest Rates

Nominal interest rates reflect the financial return an individual gets when he deposits money.
For example, a nominal interest rate of 10% per year means that an individual will receive an
additional 10% of his deposited money in the bank. Unlike the nominal interest rate, the real
interest rate considers purchasing power in the equation.

In the Fisher Effect, the nominal interest rate is the provided actual interest rate that reflects the
monetary growth padded over time to a particular amount of money or currency owed to a
financial lender. Real interest rate is the amount that mirrors the purchasing power of the
borrowed money as it grows over time.

Importance in Money Supply

The Fisher Effect is more than just an equation: It shows how the money supply affects the
nominal interest rate and inflation rate as a tandem. For example, if a change in a central bank's
monetary policy would push the country's inflation rate to rise by 10 percentage points, then the
nominal interest rate of the same economy would follow suit and increase by 10 percentage
points as well. In this light, it may be assumed that a change in the money supply will not affect
the real interest rate. It will, however, directly reflect changes in the nominal interest rate.

The International Fisher Effect (IFE)

The International Fisher Effect (IFE) is an exchange-rate model that extends the standard Fisher
Effect and is used in forex trading and analysis. It is based on present and future risk-free
nominal interest rates rather than pure inflation, and it is used to predict and understand the
present and future spot currency price movements. For this model to work in its purest form, it
is assumed that the risk-free aspects of capital must be allowed to free float between nations that
comprise a particular currency pair.
BIG MAC INDEX

The Big Mac index is a survey created by The Economist magazine in 1986 to measure purchasing power parity
(PPP) between nations, using the price of a McDonald's Big Mac as the benchmark.
Purchasing power parity is an economic theory which states that exchange rates over time should move in the
direction of equality across national borders in the price charged for an identical basket of goods. In this case,
the basket of goods is a Big Mac.
Big Mac Index
KEY TAKEAWAYS
 The Big Mac Index was created to measure the disparities in consumer purchasing power between
nations.
 The burger replaces the "basket of goods" traditionally used by economists to measure differences in
consumer pricing.
 The index was created with tongue in cheek but many economists say it's roughly accurate.
The Big Mac Index is also known as the Big Mac PPP or Burgonomics.
Understanding the Big Mac Index
According to PPP theory, any change in the exchange rate between nations should be reflected in a change in
the price of a basket of goods.
One of the key insights of the Big Mac Index is that a basket of goods in one country can rarely be precisely
duplicated in another country. For example, an American basket of groceries and a Japanese basket of groceries
are likely to contain very different products. A Big Mac, though, is always a Big Mac, allowing for slight local
differences in ingredients.
The editors of The Economist editors stress that the index should not be taken too seriously. "Burgernomics was
never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more
digestible," an article on the site indicates.

Based on the Big Mac Index, the British pound was undervalued by 27% against the U.S. dollar in January
2019.
Nevertheless, the Big Mac Index has become a global standard for price comparison. The website
statistica.com, for example, uses it to track local purchasing power internationally, revealing that a Big Mac is
relatively pricey in Switzerland, while people in Azerbaijan, Egypt, and Moldova are getting a bargain.
Example of the Big Mac Index
In January 2019, The Economist concluded that the British pound was undervalued by 27% against the U.S.
dollar, based on the Big Mac Index. That is, a Big Mac then cost $5.58 in the U.S. and 3.19 pounds in the U.K.
That difference suggests an implied exchange rate of 0.57%, but the actual exchange rate at that time was
0.78%.
As The Economist editors are quick to note, the Big Mac Index is not a perfect instrument.
To cite one, as of mid-2019, McDonald's has outlets in only 119 countries out of a total of 195. Thus, we cannot
use this methodology to analyze the PPP between the U.S. dollar and the Bolivian boliviano or the Icelandic
krona, among others.
Nevertheless, economists consider the index to be a fairly accurate real-world indicator of local economic
purchasing power, since the pricing of a Big Mac, like most consumer goods, must take into account local costs
of raw materials, labor, taxes, and business premises.