Theories of foreign exchange Rate

Purchasing Power Priority (PPP)

Purchasing Power Priority (PPP) is an economic concept that measures the relative purchasing power of different currencies in different countries. PPP takes into account the differences in the cost of living and inflation rates between countries when comparing the value of currencies.

In essence, PPP compares the price of a basket of goods and services in different countries, using a common currency such as the US dollar. This allows for a more accurate comparison of the purchasing power of different currencies, as it takes into account differences in the prices of goods and services between countries.

PPP is often used to compare the standards of living between countries, as it provides a more accurate measure of the actual purchasing power of different currencies. It is also used in international trade and investment to determine the true value of goods and services exchanged between countries.

However, it is important to note that PPP is not a perfect measure, as it can be affected by factors such as exchange rate fluctuations, changes in the composition of the basket of goods and services, and differences in the quality of goods and services between countries.

International fisher Effect ( IFE)

The International Fisher Effect (IFE) is an economic theory that suggests that the expected difference in inflation rates between two countries will be reflected in the exchange rate between their currencies. The IFE is based on the Fisher effect, which states that nominal interest rates in a country are determined by the real interest rate plus the expected rate of inflation.

According to the IFE, if the inflation rate in one country is expected to be higher than in another country, the currency of the country with the higher inflation rate will depreciate relative to the currency of the country with the lower inflation rate. This is because investors will demand a higher return to compensate for the expected loss in purchasing power due to higher inflation.

For example, if the inflation rate in Country A is expected to be 5% and the inflation rate in Country B is expected to be 2%, the IFE predicts that the currency of Country A will depreciate by 3% relative to the currency of Country B.

The IFE is important for understanding the relationship between inflation and exchange rates in international trade and investment. It can be used to predict the movements of exchange rates between countries and can help investors and businesses make decisions about where to invest or trade based on the expected inflation rates and exchange rate movements. However, like all economic theories, the IFE is subject to limitations and may not always accurately predict exchange rate movements.

Interest Rate Party (IRP)

Interest Rate Parity (IRP) is an economic theory that states that the difference in interest rates between two countries should be equal to the difference between the forward exchange rate and the spot exchange rate of their currencies.

In other words, according to IRP, if the interest rate in one country is higher than in another country, then the currency of the country with the higher interest rate will depreciate in the forward exchange rate by an amount that exactly offsets the difference in interest rates. This should result in an equal return on investment between the two currencies, regardless of which currency is used for the investment.

For example, if the interest rate in Country A is 5% and the interest rate in Country B is 3%, according to IRP, the forward exchange rate should reflect a depreciation of the currency of Country A by 2% relative to the currency of Country B, so that investors earn an equal return on investment regardless of which currency they use.

IRP is an important concept in international finance, as it helps explain the relationship between interest rates and exchange rates, and is used to determine the appropriate forward exchange rate for currencies in international trade and investment. However, like all economic theories, IRP has limitations and may not always hold true in the real world, as factors such as capital controls, political risk, and transaction costs can affect exchange rates and investment returns.