Theories of Exchange Rate Determinants

in Theory

Explain the theories of exchange rate determinants.

The theories of exchange rate are divided into following categories :

DETERMINANTS OF EXCHANGE RATE IN SPOT MARKETThere are following two theories under this category :

(a)   Process of determination:  It is the interplay of demand and supply that determines the exchange rate between two countries in a floating rate-regime. For example, the exchange rate of Indian rupee and the US dollar depends upon the demand for the US dollar and supply of dollar in Indian foreign exchange market.  The demand for foreign currency comes from individuals and firms who have to make payments to foreigners in foreign currency, mostly on account of import exchange result, services and purchase of securities.  The supply of foreign exchange results from the receipt of foreign currency, normally on account of export or sale of financial securities to the foreigners.

In the following figure, the demand curve slopes downwards to the right because the higher the value of US dollar, the costlier the imports and the importers curtails the demand for higher value of the US dollar makes export cheaper and thereby, stimulates the demand for export.  The supply of US dollar increases in the form of export earnings.  This why, the supply curve of US dollar moves downwards to the right with a rise in its value. The equilibrium exchange rate arrives where the supply curve intersects the demand curve at Q1.

If the demand for import rises owing to some factors at home, the demand for the US dollar will rise to D1 and intersect the supply curve at Q2.  The exchange rate will be Rs 42/US$.  But if the export rises as a result to decline in value of rupee and supply of the dollar increase to S1, the exchange rate will again be Rs 40/US$.  So the frequent shifts in demand and supply condition cause the exchange rate to adjust to a new equilibrium.

(b)   Purchasing Power Parity Theory (PPP):  This theory was compounded byCassel in 1921. There are two version of this theory :

(i) Absolute Version ; The theory suggest that at any point of time, the rate of exchange between two currencies  is determined by their purchasing power.  If e is the exchange rate and Pa and Pb are the purchasing power of the currencies in the two countries, A and B, the equation can be written as :

e = Pa / Pb


This theory is based on the theory of oneprice in which the domestic price of any commodity equals its foreign quoted in the same currency.  For example, if the exchange rate is Rs 2/US$, the price of a particular commodity must be US $ 50 in theUSA if it is Rs 100 inIndia.

US$ price of commodity x price of US$ = Rupee price of the commodity

The exchange rate adjustment resulting from inflation may be explained further.  If the Indian commodity turns costlier, its export will fall.  At the same time, its import from theUSAwill expand as the import gets cheaper.  Higher import will raise the demand for the US dollar raising, in turn its value vis-à-vis.

Limitation :  however this theory holds good if the same commodity are included in the same proportion in the domestic market and world market.  Since it is normally not so, the theory faces a serious limitation as it does not cover non-traded goods and services, where the transaction costs are significant.

(ii) Relative version: To overcome the limitation of absolute version, this theory has evolved. This version ofPPP theory states that the exchange rate between the currencies of two countries should be constant multiple of the general price indices prevailing in the two countries.  In other words, the percentage change in the exchange rates should equal the percentage change in the ratio of price indices in the two countries.  For example, if India has inflation rate of 5% and the USA has a 3% rate of inflation and if the initial exchange rate is Rs 40/US$, the value of the rupee in two years period will be

e2 = 40[1.05/1.03]2 or Rs 41.75/US$

The theory suggests that a country with a high rate of inflation should devalue its currency relative to the currency of the countries with lower rate of inflation.

Assumption:  The theory holds good if :

  • Changes in the economy originate from the monetary sector.
  • The relative price structure remains stable in different sectors in view of the fact that change in the relative price of various goods and services may lead differently constructed indices to deviate from each other.
  • There is no structural change in the economy, such as change in tariff, in technology and in autonomous capital flow.

Limitation of PPP:  A number of studies have empirically tested the two version of the PPP theory.  There are three factors why this theory does not hold good in real life :

  • The assumptions of this theory do not necessarily hold well in real life. 
  • There are other factors such as interest rate, governmental interference and so on that influences the exchange rate.  In 1990, some of the European Countries experienced a higher inflation rate than in theUSA, but their currency did not depreciate against dollar in view of high interest rate attracting capital from theUSA.

When no domestic substitute is available for import, goods are imported even after their prices rise in the exporting countries.

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Theories of Exchange Rate Determinants

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This article was published on 2012/03/22