(b) Purchasing Parity (PPP): This theory focuses on the rate’ relationship. ‘inflation-exchange There are two forms of PPP theory: Absolute Form- Also called the of One Price’ suggests that of similar products of two • ‘Law “prices different countries should be equal when measured in a common currency”. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices should converge. Relative Form An alternative version that accounts for the possibility of market imperfections • – such as transportation costs, tariffs, and quotas. It suggests that of these market ‘because imperfections, prices of similar products of different countries will not necessarily be the same when measured in a common currency.’ In Equilibrium Form: PF PD S = α Where, S (`/$) = spot rate PD = is the price level in India, the domestic market. PF = is the level in the foreign market, the US in this case. = Sectoral and sectoral shares constant. Α (c) International Fisher Effect (IFE): According to this theory, risk-free interest rates contain ‘nominal a real rate of return and anticipated inflation’. This means if investors of all countries require the same real return, interest rate differentials between countries may be the result of differential in expected inflation. The IFE equation can be given by: rD PD = rF or PD PF = = rD – – ΔPF – ΔS –rF 7. Comparison of PPP, IRP AND IFE Theories Theory Key Variables Summary Interest Rate Parity (IRP) Forward rate premium (or discount) Interest rate differential The forward rate of one currency will contain a premium (or discount) that is determined by the differential in interest between the two countries. Purchasing Power Parity (PPP) Percentage change in spot exchange rate Inflation rate differential The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between two countries. International Fisher Effect (IFE) Percentage change in spot exchange rate Interest rate differential The spot rate of one currency with respect to another will change in accordance with the differential in interest rates between the two countries.
(b) Purchasing Parity (PPP): This theory focuses on the ‘inflation-exchange rate’ relationship. There are two forms of PPP theory: • Absolute Form- Also called the ‘Law of One Price’ suggests that “prices of similar products of two different countries should be equal when measured in a common currency”. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices should converge. • Relative Form – An alternative version that accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas. It suggests that ‘because of these market imperfections, prices of similar products of different countries will not necessarily be the same when measured in a common currency.’ In Equilibrium Form: PF PD S = α Where, S (`/$) = spot rate PD = is the price level in India, the domestic market. PF = is the level in the foreign market, the US in this case. Α = Sectoral and sectoral shares constant. (c) International Fisher Effect (IFE): According to this theory, ‘nominal risk-free interest rates contain a real rate of return and anticipated inflation’. This means if investors of all countries require the same real return, interest rate differentials between countries may be the result of differential in expected inflation. The IFE equation can be given by: rD – PD = rF – ΔPF or PD – PF = ΔS = rD –rF 7. Comparison of PPP, IRP AND IFE Theories Theory Key Variables Summary Interest Rate Parity (IRP) Forward rate premium (or discount) Interest rate differential The forward rate of one currency will contain a premium (or discount) that is determined by the differential in interest between the two countries. Purchasing Power Parity (PPP) Percentage change in spot exchange rate Inflation rate differential The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between two countries. International Fisher Effect (IFE) Percentage change in spot exchange rate Interest rate differential The spot rate of one currency with respect to another will change in accordance with the differential in interest rates between the two countries.
sfm-theory-notes.docx