Exchange rate determination explains why currencies appreciate or depreciate. In exams, you are usually asked to explain theories and link them to practical factors like inflation, interest rates, and money supply. The important thing is to remember: no single theory works perfectly at all times, but each theory gives a useful viewpoint for different horizons.
This topic covers the most common foundational theories:
Exchange rate is the price of one currency in terms of another (e.g., USD/INR).
Broad determinants:
PPP says that in the long run, exchange rates adjust so that identical goods have the same price in different countries (after converting currency).
In simple words:
Absolute PPP compares price levels directly:
This is hard to apply perfectly because price baskets differ and trade barriers exist.
Relative PPP focuses on inflation rate differences:
If India inflation > US inflation, INR is expected to depreciate against USD over time (other factors equal).
Implications:
Limitations:
IRP links spot rate, forward rate, and interest rates across countries.
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Exchange rate determination explains why currencies appreciate or depreciate. In exams, you are usually asked to explain theories and link them to practical factors like inflation, interest rates, and money supply. The important thing is to remember: no single theory works perfectly at all times, but each theory gives a useful viewpoint for different horizons.
This topic covers the most common foundational theories:
Exchange rate is the price of one currency in terms of another (e.g., USD/INR).
Broad determinants:
PPP says that in the long run, exchange rates adjust so that identical goods have the same price in different countries (after converting currency).
In simple words:
Absolute PPP compares price levels directly:
This is hard to apply perfectly because price baskets differ and trade barriers exist.
Relative PPP focuses on inflation rate differences:
If India inflation > US inflation, INR is expected to depreciate against USD over time (other factors equal).
Implications:
Limitations:
IRP links spot rate, forward rate, and interest rates across countries.
Idea:
If domestic interest rate is higher than foreign rate, domestic currency tends to trade at forward discount (depending on quote convention), so that covered returns equalize.
In practice, UIP may not hold well due to risk premium and market frictions.
Nominal interest rate ≈ real interest rate + expected inflation.
Meaning:
IFE links interest rate differentials to expected exchange rate changes:
Monetary approach views exchange rate as the relative price of two monies.
Key idea:
It emphasizes:
If domestic prices rise faster than foreign prices, real exchange rate can appreciate even if nominal depreciates slightly—reducing export competitiveness.
Short-run practical drivers:
Exam note: Always mention that theories give base direction, but real-world exchange rates also depend on expectations and capital flows.
Higher inflation (home) → home goods become costlier → exports fall/imports rise → demand for foreign currency rises → home currency depreciates
Interest rate difference → potential profit → covered arbitrage (spot + forward) → forward premium/discount adjusts → no risk-free gain
From this topic
Table:
Thus, relative PPP is commonly used to explain currency depreciation due to higher inflation.
Limitations of PPP (any five):
Hence, PPP is mainly a long-run guide, not a perfect short-run predictor.
Meaning: Nominal interest rate consists of real interest rate plus expected inflation.
Implication:
Meaning: Differences in nominal interest rates between two countries reflect expected changes in exchange rate.
Table:
Conclusion: FE explains why interest rates differ across countries, and IFE explains how those differences relate to expected currency movement.