There are several factors which affect the exchange rate. Over the years researchers have come up with various relationships to structure exchange rate movement. But, we need to understand that prediction of the exact exchange rate movement is practically impossible. Another important thing to remember that the relationships tentatively hold in stable markets. During international market distress, rationality is often abandoned due to panic and exchange rates may not follow any relationships.
PURCHASING POWER PARITY (PPP)
The effect of relative inflation on the exchange rate is formalised as the Purchasing Power Parity (PPP) Theory. The PPP theory is based on Law of One Price which states that the price of one good, asset, security etc. should be the same in two economies when currency exchange rates are taken into consideration.
1. Absolute PPP theory
Exchange Rate of Currency = (Wt. Avg Price of basket of goods in price currency) / ( Wt. Avg Price of basket of goods in base currency)
The USD / INR exchange rate, according to Absolute PPP is the ratio of the weighted average price of a basket of goods in India in INR and the weighted average price of the same basket of goods in America in USD.
You can easily calculate that Absolute PPP does not hold in reality. The reason is that the internal logic behind the Absolute PPP is an arbitrage opportunity. It assumes that when the relative price between the two economies vary, start traders can buy from one economy and sell in the other economy. In reality, there are frictions such as tariffs, transportation costs, taxes an duties etc which makes arbitrage expensive if not impossible.
2. Relative PPP theory
Changes in Exchange Rate of Currency = Changes in (Wt. Avg Price of basket of goods in price currency) / ( Wt. Avg Price of basket of goods in base currency)
So, the Relative PPP theory says that the movement in the exchange rate is based on the movement in the relative prices. The changes in the relative prices are caused by inflation. Consider the example of the exchange rate of USD / INR. According to Relative PPP, the exchange rate should increase when the Inflation in India (INR is the price currency) is higher than the US (USD is the base currency). Note that an increase in the USD / INR exchange rate means depreciation of INR in terms of USD.
So, the higher relative inflation causes the currency to depreciate at least in the short term. Prolonged higher inflation causes the central bank to increase the interest rates which may cause the currency to appreciate.
To be continued...
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