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THEORIES BEHING EXCHANGE RATE DETERMINATION

Different studies have given us different ways of estimating the exchange rates. Even when the

exchange rates are primarily determined by the actions of demand and supply of the currency in the

market, these studies give us a theoretical reasoning behind the estimations. Exchange rate theoriescan be primarily classified as: partial equilibrium models, general equilibrium models and

disequilibrium or hybrid models.

Partial equilibrium models include relative PPP and absolute PPP, which only consider the goods market;

and covered interest rate parity (CIRP) and uncovered interest rate parity (UCIRP), which only

considers the assets market, and the external equilibrium model, which states that the exchange

rate is determined by the balance of payments.

Purchasing Price Parity : Also called Inflation Price Theory, states that a goods price in one country

should be equal to the price of the same good in another country, exchanged at nothing but the

current exchange rate and this is called One Price Law. The theory has two versions:

a) Absolute PPP Theory: According to absolute PPP theory the exchange rate between twocurrencies is determined by the ratio of price levels between the two countries, which is the

weighted average of goods produced by the countries. It is an academic concept as the PPP

theory works only and only if two countries produce and consume the goods. Apart from that, it

assumes that there are no transportation and transaction costs involved. However,

transportation costs are significant and vary significantly across the globe. Under this theory the

brand names were disregarded. The absolute PPP is considered as a partial equilibrium theory

and not the general one because it doesnt deal with the money markets and the balance

international payments.

b) Relative PPP Theory: Relative PPP Theory is more general version of Absolute PPP Theory and itstates that the percentage change in the currency exchange rate in a given time period shouldbe equal to the difference between the changes in the domestic and the foreign price level. It

assumes that the transactional costs are related proportionately to price level in order to

generate the relative PPP.

The relative PPP has its shortcomings too because of the fact that the currency exchange rates

move independently of the changes in the domestic prices and the foreign prices.

Interest Rate Parity: Often seen, the rise and fall of the home interest rate is usually followed by the

appreciation and depreciation of the home currency respectively. This indicates that the price of assets

plays a role in exchange rate variations. The interest rate parity condition was developed by Keynes

(1923), as what is called interest rate parity nowadays, to link the exchange rate, interest rate and

inflation. The theory also has two forms: covered interest rate parity (CIRP) and uncovered interest rate

parity (UCIRP).

a) CIRP: Describes the relationship of the spot market and forward market exchange rates withinterest rates on bonds in two economies. CIRP states that exchange rate forward premiums

(discounts) offset interest rate differentials between two sovereigns. In another words, the

arbitrage opportunities arising due to difference in interest rates in two sovereign is offset by

the change in spot/forward currency premiums.

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b) UCIRP: Describes the relationship of the spot and expected exchange rate with nominal interestrates on bonds in two economies. It states that the difference in interest rates between two

countries is equal to the expected change in exchange rates between the countries currencies.

If this parity does not exist, there is an opportunity to make a profit.

In recent years the interest rate parity model has shown little proof of working. In many cases,

countries with higher interest rates often experience it's currency appreciate due to higher

demands and higher yields and has nothing to do with risk-less arbitrage. Interest Rate Parity

forms the basis of Modern Asset Based Exchange Rate Model which we will discuss at the end of

these

Theories of Elasticity: According to the theories of Elasticity in Currency Exchange Rates, the currency

exchange rate is the price of foreign exchange with the help of which the equilibrium for the balance of

payments is maintained. It can also be defined as, the extent to which the exchange rate in currency

exchange rate theory responds to a fluctuation in the trade depending entirely on the elasticity of

demands to the change in prices The elasticity approach in theory of currency exchange rate is not

reliable as the exchange rates vary very frequently changing the rules of the game.

The above mentioned theories are Partial Equilibrium Theories which take into consideration only one

factor each, ie. Price levels, interest rates and Balance of Payments respectively.

THE ASSET BASED APPROACH

In recent years, it has become clear that the world does not work in the simple way just considered. For

instance, with financial liberalization the volume of international trade in financial assets now dwarfs

trade in goods and services. Moreover, in some instances countries with trade surpluses have

depreciating currencies, whereas countries with trade deficits have appreciating currencies. Economists

have responded to such real-world events by devising several alternative views of exchange rate

determination. These theories place a much greater emphasis on the role of the exchange rate as one of

many prices in the worldwide market for financial assets.

Modern exchange rate models emphasize financial-asset markets. Rather than the traditional view of

exchange rates adjusting to equilibrate international trade in goods, the exchange rate is viewed as

adjusting to equilibrate international trade in financial assets. Because goods prices adjust slowly

relative to financial asset prices and financial assets are traded continuously each business day, the shift

in emphasis from goods markets to asset markets has important implications. Exchange rates will

change every day or even every minute as supplies of and demands for financial assets of different

nations change. An implication of the asset approach is that exchange rates should be much more

variable than goods prices.

Exchange rate models emphasizing financial-asset markets typically assume perfect capital mobility. In

other words, capital flows freely between nations as there are no significant transactions costs or capitalcontrols to serve as barriers to investment.