theories of foreign exchange

theories of foreign exchange- Large holdings of foreign exchange reserves
 required - Fixed exchange rates require a
The foreign exchange market is the market in whichgovernment to hold large scale reserves of foreign
foreign currency—e.g., the yen or euro orcurrency to maintain the fixed rate - such reserves
pound—is traded for domestic currency—e.g.,have an opportunity cost.
the U.S. dollar. It is not in a centralized location and,- Loss of freedom in your internal policy - The needs
instead, is a decentralized network that is,of the exchange rate can dominate policy and this
nevertheless, highly integrated via modern informationmay not be best for the economy at that point.
and telecommunications technology. Interest rates and other policies may be set for the
The exchange rate is the price of foreign currency.value of the exchange rate rather than the more
For example, the exchange rate between the Britishimportant macro objectives of inflation and
pound and the U.S. dollar is usually stated in dollars perunemployment.
pound sterling ($/₤); an increase in this exchange- Fixed rates are inherently unstable - Countries within
rate from, say, $1.80 to say, $1.83, is a depreciationa fixed rate mechanism often follow different
of the dollar. The exchange rate between theeconomic policies, the result of which tends to be
Japanese yen and the U.S. dollar is usually stated indiffering rates of inflation. What this means is that
yen per dollar (¥/$); an increase in this exchangesome countries will have low inflation and be very
rate from, say, ¥108 to ¥110 is an appreciation ofcompetitive and others will have high inflation and not
the dollar. Some countries float their exchange rate,be very competitive. The uncompetitive countries will
which means that the central bank (the country'sbe under severe pressure continually and may,
monetary authority) does not buy or sell foreignultimately, have to devalue. Speculators will know this
exchange, and the price is instead determined in theand thus creates further pressure on that currency
private marketplace. Like other market prices, theand, in turn, government.
exchange rate is determined by supply andArguments in Favour of a Floating Exchange Rate
demand—in this case, supply of and demand for- Automatic balance of payments adjustment - Any
foreign exchange.balance of payments disequilibrium will tend to be
 rectified by a change in the exchange rate. For
 example, if a country has a balance of payments
Some countries' governments, instead of floating, fixdeficit then the currency should depreciate. This is
their exchange rate, at least for periods of time,because imports will be greater than exports meaning
which means that the government's central bank isthe supply of sterling on the foreign exchanges will
an active trader in the foreign exchange market. Tobe increasing as importers sell pounds to pay for the
do so, the central bank buys (or sells) foreignimports. This will drive the value of the pound down.
currency depending on which is necessary to peg theThe effect of the depreciation should be to make
currency at a fixed exchange rate with the chosenyour exports cheaper and imports more expensive,
foreign currency. An increase in foreign exchangethus increasing demand for your goods abroad and
reserves will add to the money supply, which couldreducing demand for foreign goods in your own
lead to inflation if it is not offset by the monetarycountry, therefore dealing with the balance of
authorities via what are called sterilization operations.payments problem. Conversely, a balance of
Sterilization by the central bank means responding topayments surplus should be eliminated by an
increases in reserves so as to leave the total moneyappreciation of the currency.
supply unchanged. A common way to accomplish it is- Freeing internal policy - With a floating exchange
by selling bonds on the open market; a less-commonrate, balance of payments disequilibrium should be
way is to increase in reserve requirements placed onrectified by a change in the external price of the
commercial banks.currency. However, with a fixed rate, curing a deficit
Still other countries follow some regime intermediatecould involve a general deflationary policy resulting in
between pure fixing and pure floating. (Examplesunpleasant consequences for the whole economy
include bands or target zones, basket pegs, crawlingsuch as unemployment. The floating rate allows
pegs, and adjustable pegs). Many central banksgovernments freedom to pursue their own internal
practice managed floating, whereby they intervene inpolicy objectives such as growth and full employment
the foreign exchange market by leaning against thewithout external constraints.
wind. To do so, a central bank sells foreign exchange- Absence of crises - Fixed rates are often
when the exchange rate is going up, therebycharacterised by crises as pressure mounts on a
dampening its rise, and buying when it is going down.currency to devalue or revalue. The fact that, with a
The motive is to reduce the variability in thefloating rate, such changes are automatic should
exchange rate. Private speculators may do the sameremove the element of crisis from international
thing: such "stabilizing speculation"—buying low withrelations.
the plan of selling high—is profitable if the- Flexibility - Post-1973 there were great changes in
speculators correctly anticipate the direction of futurethe pattern of world trade as well as a major change
exchange rates.in world economics as a result of the OPEC oil shock.
 A fixed exchange rate would have caused major
Until the 1970s, exports and imports of merchandiseproblems at this time as some countries would be
were the most important sources of supply anduncompetitive given their inflation rate. The floating
demand for foreign exchange. Today, financialrate allows a country to re-adjust more flexibly to
transactions overwhelmingly dominate. When theexternal shocks.
exchange rate rises, it is generally because market- Lower foreign exchange reserves - A country with
participants decided to buy assets denominated ina fixed rate usually has to hold large amounts of
that currency in the hope of further appreciation.foreign currency in order to prepare for a time when
Economists believe that macroeconomic fundamentalsthey have to defend that fixed rate. These reserves
determine exchange rates in the long run. The valuehave an opportunity cost.
of a country's currency is thought to react positively,Disadvantages of the Floating Rate
for example, to such fundamentals as: an increase in- Uncertainty - The fact that a currency changes in
the growth rate of the economy; an increase in itsvalue from day to day introduces instability or
trade balance; a fall in its inflation rate; or an increaseuncertainty into trade. Sellers may be unsure of how
in its real—that is, inflation-adjusted—interestmuch money they will receive when they sell abroad
rate.or what their price actually is abroad. Of course the
 rate changing will affect price and thus sales. In a
 similar way importers never know how much it is
 going to cost them to import a given amount of
 foreign goods. This uncertainty can be reduced by
One simple model for determining the long-runhedging the foreign exchange risk on the forward
equilibrium exchange rate is based on the quantitymarket.
theory of money. The domestic version of the- Lack of investment - The uncertainty can lead to a
quantity theory says that a one-time increase in thelack of investment internally as well as from abroad.
money supply is soon reflected as a proportionate- Speculation - Speculation will tend to be an inherent
increase in the domestic price level. The internationalpart of a floating system and it can be damaging and
version says that the increase in the money supply isdestabilising for the economy, as the speculative
also reflected as a proportionate increase in theflows may often differ from the underlying pattern
exchange rate. The exchange rate, as the relativeof trade flows.
price of money (domestic per foreign) can be viewed- Lack of discipline in economic management - As
as determined by the demand for money (domesticinflation is not punished there is a danger that
relative to foreign), which is in turn influencedgovernments will follow inflationary economic policies
positively by the rate of growth of the realthat then lead to a level of inflation that can cause
economy, and negatively by the inflation rate.problems for the economy. The presence of an
A defect of the international quantity theory ofinflation target should help overcome this.
money is that it cannot account for fluctuations in- Does a floating rate automatically remedy a deficit?
the real exchange rate, as opposed to simply the- UK experience indicates that a floating exchange
nominal exchange rate. The real exchange rate israte probably does not automatically cure a balance
defined as the nominal exchange rate deflated byof payments deficit. Much depends on the price
price levels (foreign relative to domestic). It is theelasticity of demand for imports and exports. The
real exchange rate that matters most for the realMarshall-Lerner condition says that a depreciation in
economy. If a currency has a high value in real terms,the exchange rate will help improve the balance of
this means that its products are selling atpayments if the sum of the price elasticities for
less-competitive prices on world markets, which willimports and exports is greater than one.
tend to discourage exports and encourage imports. If- Inflation - The floating exchange rate can be
the real exchange rate were constant, theninflationary. Apart from not punishing inflationary
purchasing power parity would hold: the exchangeeconomies, which, in itself, encourages inflation, the
rate would be proportionate to relative price levels.float can cause inflation by allowing import prices to
Purchasing power parity does not, in fact, hold in therise as the exchange rate falls. This is, undoubtedly,
short run, not even approximately. It does not holdthe case for countries such as UK where we are
even for goods and services that are tradeddependent on imports of food and raw materials.
internationally. But purchasing power parity does tend 
to hold in the long run.Theory 3 - Market intervention - how can the
 government change things?
One elegant theory of exchange-rate determinationThe Bank of England can act on behalf of the
is the late Rudiger Dornbusch's "overshooting model."government to influence the level of the exchange
In this theory, an increase in the real interestrate. They have not done this since the ERM crisis of
rate—due, for example, to a tightening monetary1992, but it remains a possible option. The foreign
policy—causes the currency to appreciate more inexchange market now trades on such a significant
the short run than it will in the long run. Thescale (a net daily turnover in London of over $650
explanation is that the only way internationalbillion), that it is difficult for any one government to
investors will be willing to hold any foreign assets,influence the markets. However, governments acting
given that the rate of return on domestic assets isin a concerted way could certainly have an impact.
higher because of the monetary tightening, is if theyIf they want to intervene, the government will need
expect the value of the domestic currency to fall into use their foreign exchange reserves. They will
the future. This fall in the value of the domesticneed to buy or sell foreign currency as appropriate to
currency would make up for the lower rate of returntry to influence the market. Say, for example, that
on foreign assets. The only way the value of thethe exchange rate has been depreciating for some
domestic currency will fall in the future, given thattime because of a lot of selling of the pound, and the
the domestic currency's value rises in the short run, isgovernment wants to try to slow its fall (or even
if it rises more in the short run than in the long run.reverse it). They will need to increase the level of
Thus the term "overshooting." An advantage of thisdemand for the currency, and they do this by buying
theory over the international quantity theory ofsterling and selling other currencies.
money is that it can account for fluctuations in theWe can see all this on the diagram below. The selling
real exchange rate.of sterling pushes the supply curve to the right (S1
It is extremely difficult to predict in which directionto S2) and is forcing the exchange rate down.
exchange rates will move in the short run. EconomistsThe government decides to act, and so they sell
often view changes in exchange rates as following avarious currencies (perhaps dollars, euro or yen) and
random walk, which means that a future increase isbuy sterling in exchange. This increases the demand
as likely as a decrease. Short-run fluctuations arefor sterling, and pushes the demand curve to D2. The
difficult to explain even after the fact. Somepound has still fallen overall, but the government's
short-run movements no doubt reflect attempts byaction has slowed the fall.
market participants to ascertain the future directionIf the opposite was happening, and sterling was
of macroeconomic fundamentals. But many short-runrising, then the government would need to buy
movements are hard to explain and may be due toforeign currency and sell sterling. This would increase
ineffable determinants such as some vague "marketthe supply of sterling and help to slow down the
sentiment" or speculative bubbles. Speculative bubblesappreciation.
are movements of the exchange rate that are notTheory 4 - Effects of exchange rate changes - why
related to macroeconomic fundamentals, but thatdo they matter?
instead result from self-fulfilling changes inExchange rate changes can have a significant effect
expectations. Those who trade foreign exchange foron the economy. Let's take the example of a
a living generally look at economists' models ofdepreciation of the exchange rate, and see what
fundamentals when thinking about horizons of oneimpact this has.
year or longer. At horizons of a month or less, theyIf the exchange rate falls, this changes the relative
tend to rely more on methods unrelated to economicprices of imports and exports. Exports will appear to
fundamentals, such as "technical analysis." A commonbecome relatively cheaper in other currencies, and
technical-analysis strategy is to buy currencyimports will appear to be more expensive. Because
whenever the short-run moving average rises abovewe buy imports, they are included as part of the
the long-run moving average, and sell when it goesretail price index, and so if the price of imports goes
the other way.up, this could be inflationary especially as in the UK
By the 1990s, the richer countries had all butwe import a lot of raw materials and semi-finished
eliminated capital controls—that is, restrictions onproducts. There we have the first effect of a
buying and selling financial assets across their borders.depreciation - it could trigger inflationary pressures in
The poorer countries, despite a degree of marketthe economy.
opening, still have substantial restrictions. In theThe effects on aggregate demand may compound
absence of barriers to movement of financial capitalthis inflationary impact. Since exports are relatively
across borders, capital is highly mobile and financialcheaper overseas, this should increase the demand
markets are highly integrated. In this case, arbitragefor them. In addition the demand for imports should
is free to operate: investors buy assets in countriesfall. The combination of the two will have a positive
where they are cheap and sell them where they areimpact on aggregate demand because net exports is
expensive, and thereby bring prices into line. Arbitrageone of the components of the AD function (AD=
works to bring interest rates into parity acrossC+I+G+(X-M) How much the demand increases
countries. The surest form of arbitrage brings aboutdepends on the price elasticity of demand for
covered interest parity: it drives the forward discountexports, but the demand should certainly grow.
into equality with the differential in interest rates.Growth in aggregate demand could also be
Covered interest arbitrage brings about coveredinflationary if the economy is close to its capacity. On
interest parity in the absence of major transactionsthe diagram below you can see the shift in aggregate
costs, capital controls, or other barriers to thedemand (AD1 to AD2) pulling up the price level
international movement of money. Again, the(demand-pull inflation).
definition of covered interest parity is that theIn the long-run the effect of the depreciation on the
forward discount is equal to the differential in interestbalance of payments is far from certain. The impact
rates.depends on how much the demand for imports and
It is less clear if uncovered interest parity holds.exports change. That depends on the price elasticity
Under uncovered interest parity, the differential inof demand for imports and exports. When the
interest rates would equal not only the forwardexchange rate falls imports get more expensive and
discount, but also the expected rate of futureexports cheaper. That should raise the demand for
change in the exchange rate. It is hard to measureexports and lower the demand for imports. However,
whether this condition in fact holds, because it is hardfor exports we still receive the same amount in
to measure investors' private expectations. Onesterling. They are cheaper in the local currency, but
reason uncovered interest parity could easily fail iswe still receive the same amount in sterling. Imports,
the existence of an exchange-risk premium. Ifhowever, cost us more in sterling. So the overall
uncovered-interest parity holds, then countries caneffect on the balance of payments depends on the
finance unlimited deficits by borrowing abroad, so longprice elasticity of exports and imports.
as they are willing and able to pay the going worldLet us look at a simple example to illustrate:
rate of return. But if uncovered interest parity doesAssume the exchange rate between the £ and the
not hold, then countries will find that the more they€ is £1 = €2. A good, X, in the UK is priced
borrow, the higher the rate of interest they mustat £5. At this exchange rate 100 of these items are
pay.purchased from abroad - export earnings are
The following theories explain the fluctuations in FXtherefore £500. A product Y in Europe is locally
rates in a floating exchange rate regime (In fixedpriced at €5, The UK buys 200 of these items at
exchange regime, FX rates are decided by itsthe current exchange rate. This means that we have
government):to give up £2.50 to buy each unit. Total expenditure
(a)    International parity conditions: Relativeon imports therefore is £500. At this point the
Purchasing Power Parity, Interest Rate Parity,balance of payments is 0.
Domestic Fisher Effect, International fisher Effect.Let us now assume that the exchange rate
Though to some extent the above theories providedepreciates from £1 = €2 to £1 = €1.
logical explanation for the fluctuations in exchangeEuropeans buying good X from the UK will now have
rates, yet these theories falter as they are based onto give up only €5 to acquire the good rather
challengeable assumptions [e.g., free flow of goods,than the €10 they had to previously. Given that
services and capital] which seldom hold true in thethe product appears cheaper we would expect
real world.demand for exports to rise. UK buyers of good Y
 from Europe however now have to give up £5 to
(b) Balance of payments model: This model,acquire the necessary euro to buy the product. It
however, focuses largely on tradable goods andappears to the UK buyer that prices have risen and
services, ignoring the increasing role of global capitalwe would expect demand for imports to fall. The
flows. It failed to provide any explanation forprice of exports has fallen by 50% whilst the price of
continuous appreciation of dollar during 1980s andimports appears to have risen by 100%. Now let us
most part of 1990s in face of soaring US currentlook at the impact on the actual demand for imports
account deficit.and exports given two different scenarios.
(c) Asset market model : views currencies as anScenario 1:
important asset class for constructing investmentThe Price Elasticity of Demand (PED) for exports is
portfolios. Assets prices are influenced mostly by-1.4 and the PED for imports is -0.2.
people's willingness to hold the existing quantities ofDemand for exports would rise by 1.4 times the fall in
assets, which in turn depends on their expectationsprice and so would rise by 70 units. In this case,
on the future worth of these assets. The assetexport earnings would now be 170 x £5 = £850.
market model of exchange rate determination statesDemand for imports would fall by 0.2 x the change in
that "the exchange rate between two currenciesprice and so would fall by 20% - a decrease of 40
represents the price that just balances the relativeunits. Expenditure on imports would now be 160 x
supplies of, and demand for, assets denominated in£5 = £900.
those currencies."We would now have a balance of payments deficit
None of the models developed so far succeed toof £50!
explain FX rates levels and volatility in the longer timeScenario 2:
frames. For shorter time frames (less than a fewThe PED of exports is -0.8 and the PED for imports
days) algorithm can be devised to predict prices.is -0.5.
Large and small institutions and professional individualDemand for exports would rise by 0.8 x the change
traders have made consistent profits from it. It isin price = 40 units. Total export earnings would be
understood from above models that many140 x £5 = £700.
macroeconomic factors affect the exchange ratesDemand for imports would fall by 0.5 x the change in
and in the end currency prices are a result of dualprice (100%) = 50%. Import expenditure would now
forces of demand and supply. The world's currencybe 100 x £5 = £500.
markets can be viewed as a huge melting pot: in aIn this situation the balance of payments would be in
large and ever-changing mix of current events,surplus at +£200
 supply and demand factors are constantly shifting,The 'Marshall-Lerner' condition says that if the sum of
and the price of one currency in relation to anotherthe price elasticities for imports and exports is
shifts accordingly. No other market encompassesgreater than 1, then the balance of payments will
(and distills) as much of what is going on in the worldimprove. The evidence for the UK suggests that the
at any given time as foreign exchange.condition holds in the long-run, but not in the
Supply and demand for any given currency, and thusshort-run. This will mean that when the exchange
its value, are not influenced by any single element,rate depreciates, the balance of payments will initially
but rather by several. These elements generally falldeteriorate, but in the long-run it will improve. This
into three categories:  economic factors, politicalgives what is known as a 'J-curve effect'. This effect
conditions and market psychology.is shown below.
 The effect occurs because it will take time for the
 exchange rate changes to be factored in by decision
 makers - contracts will have been signed for
Theories of Foreign Exchangeexample, which will not immediately reflect any
After decades of relative neglect, economic theory,change in the exchange rate.
especially in its mathematical form, has taken a new 
life since the end of World War II. 
The renaissance has included many aspects ofTheory 5 - Exchange rate jargon - jargon-busting
international economics, but theories that purport toguide
explain the levels and movements of parities andThere is a lot of jargon associated with exchange
spot and forward exchange have been somewhatrates. In this theory section we look at some of this
neglected. The result is that parities, spot andjargon, and see what it means.
forward exchange are still a subject of research andSpot exchange rates
controversy.The spot exchange rate is the rate existing in the
In its simplest form, the purchasing power paritymarket at any given moment. It can be considered
theory affirms that the rate of exchange establishesas the rate of exchange for immediate delivery of
itself at a point that will equalize the prices in any twothe currency. The spot rate will change all the time
countries. One of the functions of the rate ofaccording to the changes in supply and demand in the
exchange, according to this theory, is to equalize themarket.
purchasing power of the several currencies.Forward exchange rates
A rate of exchange that does nothing more thanThe forward exchange rate is a rate for a given time
equalize price levels will not necessarily prove to bein the future. A price is agreed now for an exchange
an equilibrium rate. Foreign trade usually includesat some time in the future (often 3 months or so).
capital and unilateral transfer movements, and theWhatever happens to the spot rate between now
purchasing power parity theory does not pretend toand then, the contract will be met at the rate that
even out with them.was agreed. Companies may use the forward market
Adding together, nations produce many commoditiesto protect themselves against the foreign exchange
that do not enter into international trade, and therisk. They know they can buy at a guaranteed rate
prices of those domestic goods obviously cannot befor the future, and so can plan ahead. This process is
equalized internationally. Furthermore, studies ofcalled 'hedging' against risk. The existence of the
European prices and exchange rates duringforward market also creates the potential for
inflationary periods of indicate that internal price levelsspeculation. Depending on the reason for buying or
are frequently determined by rates of exchange, andselling the currency the dealer could end up better
not the other way around.off or worse off.
The purchasing power parity rate of exchange doesPurchasing Power Parity
have the signal advantage, however, of beingThe purchasing power parity exchange rate is the
relatively determinable, whereas some theories doexchange rate between two currencies, which would
not provide a practical method of calculating anenable exactly the same basket of goods to be
exchange rate or a par value. Also, since thepurchased. In other words, the rate at which
merchandise trade is the most important element ofpurchasing power will be the same in both countries.
world commercial relations, the theory does have atFor example, say a basket of goods cost $50 in the
least limited applicability. For such reasons as these, itUSA, and the same basket cost £25 in the UK. The
continues to have considerable acceptance as aPPP rate between the £ and the $ would then be
workable approach to the general movement of£1=$2. The PPP rate is often used when trying to
exchange rates.work out consistent measures between countries like
The balance of payments or the equilibrium theory ofGDP or standard of living. It will generally be different
exchange rates affirms that the exchange rates tendto the actual equilibrium exchange rate, though it will
to establish itself where it will maintain balance ofbe a factor influencing it.
payments equilibrium and eliminate surpluses andThe PPP relationship becomes a theory of exchange
deficits. The theory might be valid if the exchangerate determination by introducing assumptions about
rates were allowed to float freely and attain theirthe behavior of importers and exporters in response
market, or equilibrium levels. Under the Brettonto changes in the relative costs of national market
Woods system, however, limits are set to thebaskets. Recall, in the story of the law of one price,
fluctuations of exchange rates and governmentwhen the price of a good differed between two
intervention in the exchange markets impedes thecountry's markets, there was an incentive for
free movement of rates. Hence, the theory is moreprofit-seeking individuals to buy the good in the low
a statement of a tendency than a completeprice market and resell it in the high price market.
explanation.Similarly, if a market basket, containing many
The supply and demand theory, according to thisdifferent goods and services, costs more in one
one, the exchange rate is held to be determined bymarket than another, we should likewise expect
the supply and demand for foreign currencies.profit-seeking individuals to buy the relatively cheaper
Actually, the supply and demand theory is not agoods in the low cost market and resell them in the
theory, but instead a descriptive mechanism.higher priced market. If the law of one price leads to
To say that a rate of exchange is established bythe equalization of the prices of a good between
supply and demand is to tell how a rate istwo markets, then it seems reasonable to conclude
established, but to say a little about the factors thatthat PPP, describing the equality of market baskets
determine it or why the rate is at a given level andacross countries, should also hold.
not at some other level. All of the forces,However, adjustment within the PPP theory occurs
substantive, technical, and psychological, that havewith a twist compared to adjustment in the law of
impact on a rate of exchange, must, by the veryone price story. In the law of one price story, goods
nature of the market itself, act by determining thearbitrage in a particular product was expected to
demand for, and the supply of foreign exchange.affect the prices of the goods in the two markets.
The psychological theory--- the exchange rate isThe twist that's included in the PPP theory is that
largely conditioned by the attitudes of those whoarbitrage, occurring across a range of goods and
deal in it. If, in their opinion, a rate is below its correctservices in the market basket, will affect the
level or will rise in the future, they are inclined to butexchange rate rather than the market prices.
it; they thereby increase the demand for currencyThe PPP Equilibrium Story
and work to raise its rate. If, on the other hand,To see why the PPP relationship represents an
they feel that the rate overvalues the currency or isequilibrium we need to tell an equilibrium story. An
likely to decline, they are apt to sell their holdings andequilibrium story in an economic model is an
thereby increase the market supply of the currencyexplanation of how the behavior of individuals will
and push its rate down.cause the equilibrium condition to be satisfied. The
Lastly, the interest parity theory is the most widelyequilibrium condition is the PPP equation developed
accepted explanation of the magnitudes of forwardabove,
exchange rates. it is based on the fact thatThe endogenous variable in the PPP theory is the
short-term interest rates differ from country toexchange rate. Thus, we need to explain why the
country and also the fact that banks, which buy orexchange rate will change if it is not in equilibrium. In
sell foreign currencies forward, usually like to covergeneral there are always two versions of an
their positions by the purchase or sale of theseequilibrium story, one in which the endogenous
currencies spot.variable (Ep/$ here) is too high, and one in which it is
 too low.
 PPP Equilibrium Story 1 - Let's consider the case in
Theory 1 - Determination of exchange rates - whywhich the exchange rate is too low to be in
do they go up and down?equilibrium. This means that,where Ep/$ is the
An exchange rate is a price - exactly the same asexchange rate that prevails on the spot market and,
any other price - the amount you have to give up tosince it is less than the ratio of the market basket
acquire something else - in this case another currency.costs in Mexico and the US, is also less than the PPP
So an exchange rate is the price of one currency inexchange rate. The right-hand side of the expression
terms of another. In other words it is the price youis rewritten to show that the cost of a market
will pay in one currency to get hold of another. Thebasket in the US evaluated in pesos, CB$Ep/$, is less
price can be set in various ways. It may be fixed bythan the cost of the market basket in Mexico also
the government or it could perhaps be linked toevaluated in pesos. Thus, it is cheaper to buy the
something external - for example, gold. However, thebasket in the US, or, more profitable to sell items in
most likely alternative is that it will be fixed in athe market basket in Mexico.
market. Since it is a price, it will be determined, likeThe PPP theory now suggests that the cheaper
any other price, by demand and supply. This is thebasket in the US will lead to an increase in demand
supply and demand of pounds traded on the foreignfor goods in the US market basket by Mexico, and,
exchange market and is NOT the amount of sterlingas a consequence, will increase the demand for US
in circulation! A high level of demand for a currencydollars on the foreign exchange market. Dollars are
will force up its price - the exchange rate. Whereneeded because purchases of US goods require US
supply is equal to demand is the equilibrium exchangedollars. Alternatively, US exporters will realize that
rate, as shown in the diagram below.goods sold in the US can be sold at a higher price in
The demand for £ comes from people who areMexico. If these goods are sold in pesos, the US
investing in the UK from abroad and so need pounds,exporters will wantto convert the proceeds back to
or from firms who are buying UK exports. They willdollars. Thus, there is an increase in US dollar demand
need pounds to be able to pay for the goods. The(by Mexican importers) and an increase in peso
supply comes from people in the UK who are sellingsupply (by US exporters) on the Forex. This effect is
pounds. This may be because they have boughtrepresented by a rightward shift in the US dollar
goods from overseas (imports), or it may simply bedemand curve in the adjoining diagram. At the same
that they are investing in another country and sotime, US consumers will reduce their demand for the
need the local currency. To get this they have to sellpricier Mexican goods. This will reduce the supply of
pounds in exchange for the other currency.dollars (in exchange for pesos) on the Forex which is
The equilibrium rate is where supply is equal torepresented by a leftward shift in the US dollar
demand, and this will change as supply and demandsupply curve in the Forex market.
changes. Say, for example, that interest ratesBoth the shift in demand and supply will cause an
increase. This will tend to attract more overseasincrease in the value of the dollar and thus the
investment into the UK. To invest here, they willexchange rate, Ep/$, will rise. As long as the US
need to buy pounds, and so the demand for poundsmarket basket remains cheaper, excess demand for
will rise. We can see this on the diagram below:the dollar will persist and the exchange rate will
As we can see, both the exchange rate and thecontinue to rise. The pressure for change ceases
volume of currency traded have increased. This willonce the exchange rate rises enough to equalize the
not inevitably be the effect as there may be othercost of market baskets between the two countries
factors affecting the exchange rate at the sameand PPP holds.
time. A lot will also depend on whether the foreignPPP Equilibrium Story 2 - Now let's consider the other
exchange market expected the interest rate increaseequilibrium story, that is, the case in which the
or not. However, supply and demand gives us a veryexchange rate is too high to be in equilibrium. This
useful tool for analysing movements in the exchangeimplies that,
rate.The left-hand side expression says that the spot
Theory 2 - Fixed v. floating - which will sink and whichexchange rate is greater than the ratio of the costs
will swim?of market baskets between Mexico and the US. In
The two principal ways of determining the exchangeother words the exchange rate is above the PPP
rate are either to fix it against another currency orexchange rate. The right-hand side expression says
to allow it to float freely in the market and find itsthat the cost of a US market basket, converted to
own level. These two systems are respectivelypesos at the current exchange rate, is greater than
known as 'fixed' rates and 'floating' rates.the cost of a Mexican market basket in pesos. Thus,
Fixed rateson average US goods are relatively more expensive
A fixed exchange rate is a system where thewhile Mexican goods are relatively cheaper.
exchange rate has a set value against anotherThe price discrepancies should lead consumers in the
currency. For much of the post-war period sterlingUS, or importing firms, to purchase less expensive
was fixed against the dollar and it was only floated ingoods in Mexico. To do so, they will raise the supply
1972 when a fixed rate became unsustainable. Toof dollars in the Forex in exchange for pesos. Thus,
maintain a fixed exchange rate, the governmentthe supply curve of dollars will shift to the right as
needs to have a significant level of foreign currencyshown in the adjoining diagram. At the same time,
reserves. A fixed exchange rate does not keep itselfMexican consumers would refrain from purchasing the
at the same level. The government has to activelymore expensive US goods. This would lead to a
intervene in the markets to keep it at the fixed rate.reduction in demand for dollars in exchange for pesos
If, for example, there was an increase in demand foron the Forex. Hence the demand curve for dollars
the currency (shown by a shift from D1 to D2shifts to the left. Due to the demand decrease and
below), this would normally lead to the exchange ratethe supply increase, the exchange rate, Ep/$, falls.
increasing. However, the exchange rate is fixed andThis means that the dollar depreciates and the peso
so the authorities have to counter the effect of theappreciates.
increase in demand. They do this by supplying moreExtra demand for pesos will continue as long as
of the currency. In other words they sell sterling andgoods and services remain cheaper in Mexico.
buy other currencies instead. This shifts the supplyHowever, as the peso appreciates (the $
curve to S2, and maintains the fixed rate.depreciates) the cost of Mexican goods rises relative
To maintain the exchange rate, the government hadto US goods. The process ceases once the PPP
to sell sterling and buy foreign currency, thereforeexchange rate is reached and market baskets cost
increasing their holdings of foreign currency.the same in both markets.
Floating ratesAdjustment to Price Level Changes Under PPP
A floating exchange rate is one that is allowed to findIn the PPP theory, exchange rate changes are
its own level according to the forces of supply andinduced by changes in relative price levels between
demand. The demand for £ comes from peopletwo countries. This is true because the quantities of
who are investing in the UK from abroad and sothe goods are always presumed to remain fixed in
need pounds, or from firms who are buying UKthe market baskets. Therefore, the only way that
exports. They will need pounds to be able to pay forthe cost of the basket can change is if the goods'
the goods. The supply comes from people in the UKprices change. Since price level changes represent
who are selling pounds. This may be because theyinflation rates, this means that differential inflation
have bought goods from overseas (imports), or itrates will induce exchange rate changes according to
may simply be that they are investing in anotherthe theory.
country and so need the local currency. To get thisIf we imagine that a country begins with PPP, then
they have to sell pounds in exchange for the otherthe inequality given in equilibrium story #1,
currency.  ,can arise if the price level rises in Mexico (peso
The equilibrium rate is where supply is equal toinflation), if the price level falls in the US ($ deflation),
demand, and this will change as supply and demandor if Mexican inflation is more rapid than US inflation.
changes. We can see this in the diagram below whichAccording to the theory, the behavior of importers
shows an increase in demand for sterling - theand exporters would now induce a dollar appreciation
shortage created on the market would lead to theand a peso depreciation.In summary,an increase in
exchange rate rising, settling at a new equilibrium levelMexican prices relative to the change in US prices (i.e.,
of €1.65more rapid inflation in Mexico than in the US) will
cause the dollar to appreciate and the peso to
Arguments in Favour of a Fixed Ratedepreciate according to the purchasing power parity
- Reduced risk in international trade - By maintaining atheory.
fixed rate, buyers and sellers of goods internationallySimilarly, if a country begins with PPP, then the
can agree a price and not be subject to the risk ofinequality given in equilibrium story #2,
later changes in the exchange rate before contracts  ,
are settled. The greater certainty should help can arise if the price level rises in the US ($
encourage investment.inflation), the price level falls in Mexico (peso
- Introduces discipline in economic management - Asdeflation) or if US inflation is more rapid than Mexican
the burden or pain of adjustment to equilibrium isinflation. In this case, the inequality would affect the
thrown onto the domestic economy thenbehavior of importers and exporters and induce a
governments have a built-in incentive not to followdollar depreciation and peso appreciation. In summary,
inflationary policies. If they do, then unemploymentmore rapid inflation in the US would cause the dollar
and balance of payments problems are certain toto depreciate while the peso would appreciate.
result as the economy becomes uncompetitive. 
- Fixed rates should eliminate destabilising speculation -Effective Exchange Rate
Speculation flows can be very destabilising for anThe effective exchange rate is also called the 'sterling
economy and the incentive to speculate is very smallindex' or perhaps the 'sterling trade-weighted index'. It
when the exchange rate is fixed.is an exchange rate calculated from a basket of
Disadvantages of the Fixed Exchange Ratecurrencies, and can perhaps best be thought of as an
- No automatic balance of payments adjustment - Aaverage exchange rate. Each of the currencies
floating exchange rate should deal with a disequilibriumincluded is weighted according to its importance to us.
in the balance of payments without governmentThis is worked out from the amount of trade we do
interference, and with no effect on the domesticwith that country. The currency of a country that
economy. If there is a deficit then the currency fallswe do a large amount of trade with will have a
making you competitive again. However, with a fixedhigher weight than one whom we do relatively little
rate, the problem would have to be solved by atrade with. The effective exchange rate can be a
reduction in the level of aggregate demand. Asuseful indicator, as it shows overall exchange rate
demand drops people consume less imports and alsochanges.
the price level falls making you more competitive.