Exchange Rate Determination: PPP, Interest Rate Parity, Fisher Effect and Monetary Approach (Basics) Questions

Question 1

Define Purchasing Power Parity (PPP).

Accepted Answer

**PPP (Purchasing Power Parity)** states that in the long run, exchange rates adjust so that identical goods have the same price across countries after currency conversion (prices/inflation drive exchange rate).

Question 2

What is Interest Rate Parity (IRP)?

Accepted Answer

**Interest Rate Parity (IRP)** is the condition that links spot and forward exchange rates with interest rate differences between two countries to prevent risk-free arbitrage.

Question 3

State Fisher Effect (in words).

Accepted Answer

**Fisher Effect** says that nominal interest rate is approximately equal to real interest rate plus expected inflation.

Question 4

What is forward premium?

Accepted Answer

**Forward premium** means the forward exchange rate is higher than the spot rate for the same quote convention (Forward > Spot).

Question 5

What is nominal exchange rate?

Accepted Answer

**Nominal exchange rate** is the market rate at which one currency exchanges for another (e.g., USD/INR).

Question 6

Expand PPP.

Accepted Answer

**PPP** = **Purchasing Power Parity**.

Question 7

Differentiate absolute PPP and relative PPP (any three points) with a small table.

Accepted Answer

### **Absolute PPP vs Relative PPP**

- **Absolute PPP** compares overall price levels to estimate exchange rate.
- **Relative PPP** focuses on inflation rate differences and predicts % change in exchange rate.
- Relative PPP is more practical for exams/forecasting because it avoids needing identical baskets.

Table:

| Aspect | **Absolute PPP** | **Relative PPP** |
|---|---|---|
| Based on | price levels | inflation rates |
| Output | level of exchange rate | % change in exchange rate |
| Use | theoretical benchmark | practical long-run trend |

Thus, relative PPP is commonly used to explain currency depreciation due to higher inflation.

Question 8

Explain limitations of PPP (any five points).

Accepted Answer

Limitations of PPP (any five):

- transport cost and **trade barriers** (tariffs/quotas).
- presence of **non-tradable** goods/services.
- different consumption baskets and quality differences.
- market imperfections and price stickiness.
- in the short run, capital flows and expectations dominate.

Hence, PPP is mainly a long-run guide, not a perfect short-run predictor.

Question 9

Explain Interest Rate Parity (IRP) concept (any three points) with a simple flow.

Accepted Answer

### **Interest Rate Parity (IRP)**

Key points (any three):
- IRP links **spot rate, forward rate and interest rates** across countries.
- if interest rates differ, forward premium/discount adjusts so covered returns become equal.
- IRP prevents **risk-free arbitrage** opportunities.

Flow:

```text
Interest rate difference → potential profit → covered arbitrage (spot + forward) → forward rate adjusts → no-arbitrage condition
```

Thus, IRP explains why forward rates differ from spot rates.

Question 10

Explain covered vs uncovered interest parity (any three points) with a table.

Accepted Answer

### **Covered vs Uncovered Interest Parity**

- **Covered** parity uses forward contract, so exchange risk is removed.
- **Uncovered** parity does not hedge; relies on expected spot rate movement.
- UIP may deviate due to risk premium and expectations.

Table:

| Basis | **CIP (Covered)** | **UIP (Uncovered)** |
|---|---|---|
| Hedge used | yes (forward) | no |
| Risk | low FX risk | FX risk remains |
| Works well | generally strong in liquid markets | weaker in practice |

Hence, covered parity is more reliable for explaining forward pricing.

Question 11

Explain practical factors that move exchange rates in the short run (any five points).

Accepted Answer

Short-run exchange rate drivers (any five):

- **capital flows** (FPI inflows/outflows react quickly).
- central bank intervention and policy expectations.
- market **sentiment** (risk-on/risk-off) and global events.
- commodity price shocks (e.g., oil price for import-dependent countries).
- political stability, credit rating changes and country risk news.
- speculation and expectations based on future growth/inflation.

Hence, short-run exchange rates often move more due to expectations and capital flows than due to long-run PPP factors.

Question 12

Explain monetary approach in brief and state any two implications (3-mark).

Accepted Answer

### **Monetary Approach (Brief)**

Monetary approach treats exchange rate as the relative price of two currencies and focuses on **money supply and money demand**.

Implications (any two):
- if domestic **money supply** grows faster than money demand (and faster than foreign), domestic currency tends to **depreciate**.
- sustained monetary expansion can raise inflation, reinforcing depreciation over time.

Thus, monetary conditions are important for understanding long-run exchange rate trends.

Question 13

Explain Fisher Effect and International Fisher Effect (IFE) (exam-style) with a table.

Accepted Answer

### **Fisher Effect and International Fisher Effect (IFE) — Exam-Style**

#### **Fisher Effect (FE)**
**Meaning:** Nominal interest rate consists of real interest rate plus expected inflation.
- **Nominal rate ≈ Real rate + Expected inflation**

Implication:
- countries with higher expected inflation generally have higher nominal interest rates.

#### **International Fisher Effect (IFE)**
**Meaning:** Differences in nominal interest rates between two countries reflect expected changes in exchange rate.
- the currency with **higher nominal interest rate** is expected to **depreciate** (on average).

Table:

| Concept | Links | Key idea |
|---|---|---|
| **FE** | interest rate ↔ inflation | nominal includes inflation |
| **IFE** | interest differential ↔ expected FX change | higher i → expected depreciation |

**Conclusion:** FE explains why interest rates differ across countries, and IFE explains how those differences relate to expected currency movement.

Question 14

Explain monetary approach to exchange rate determination (exam-style) with a flowchart.

Accepted Answer

### **Monetary Approach to Exchange Rate — Exam-Style**

**Meaning:** Monetary approach views exchange rate as the relative price of two currencies (two monies). It emphasizes **money supply and money demand** in determining exchange rate.

#### **Core idea**
- if a country increases **money supply** faster than money demand (and faster than another country), its currency tends to **depreciate**.
- higher money supply can raise domestic price level (inflation), reinforcing depreciation.

Flowchart:

```text
Increase money supply (home) → excess money balances → higher spending/prices → higher inflation → home currency depreciation
```

**Conclusion:** Monetary approach explains long-run currency movements through relative monetary conditions and inflation trends.

Question 15

Explain real vs nominal exchange rate and why real rate matters (exam-style) with a small table.

Accepted Answer

### **Nominal vs Real Exchange Rate — Exam-Style**

#### **Nominal exchange rate**
- the observed market rate (e.g., USD/INR).

#### **Real exchange rate**
- nominal exchange rate adjusted for relative price levels (inflation) between countries.
- shows **competitiveness** of domestic goods relative to foreign goods.

Why real rate matters:
- if real exchange rate **appreciates**, domestic goods become relatively expensive → exports may fall and imports may rise.
- if real exchange rate **depreciates**, domestic goods become relatively cheaper → export competitiveness improves.

Table:

| Rate | Adjusts for inflation? | What it shows |
|---|---|---|
| **Nominal** | No | market conversion rate |
| **Real** | Yes | trade competitiveness |

**Conclusion:** Real exchange rate is more meaningful for trade competitiveness and long-run external balance analysis.

Aspect	Absolute PPP	Relative PPP
Based on	price levels	inflation rates
Output	level of exchange rate	% change in exchange rate
Use	theoretical benchmark	practical long-run trend

Exchange Rate Determination: PPP, Interest Rate Parity, Fisher Effect and Monetary Approach (Basics)

Absolute PPP vs Relative PPP

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