explanation of the theories of exchange rate determination, which explain how the value of a country's currency is determined in relation to another currency
20/June/2025 01:20
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Here is a detailed explanation of the theories of exchange rate determination, which explain how the value of a country's currency is determined in relation to another currency:
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Theories of Exchange Rate Determination
These theories attempt to explain how and why exchange rates fluctuate or remain stable over time. The major theories include:
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1. Purchasing Power Parity (PPP) Theory
Definition:
This theory states that the exchange rate between two currencies is determined by the relative purchasing power of those currencies in their respective countries.
Formula:
Exchange Rate = Price Level in Domestic Country / Price Level in Foreign Country
Example:
If a basket of goods costs ₹1000 in India and $10 in the USA, the exchange rate should be ₹1000/$10 = ₹100 per $1.
Assumptions:
No transportation costs
No trade restrictions (tariffs, quotas)
Identical goods in both countries
Limitations:
Not realistic in the short term due to market imperfections, inflation differences, and government policies.
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2. Interest Rate Parity (IRP) Theory
Definition:
This theory states that the difference in interest rates between two countries will be offset by the change in exchange rates.
Implication:
Investors should earn the same return in both countries after accounting for exchange rate changes, preventing arbitrage opportunities.
Helps in predicting forward exchange rates and guiding investment decisions in international finance.
Limitations:
Assumes perfect capital mobility
Ignores transaction costs and risks
Not always accurate in the real world
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3. Balance of Payments (BOP) Theory
Definition:
This theory states that the exchange rate is determined by a country's balance of payments position — the difference between its total exports and total imports (including services and capital flows).
Implication:
A surplus in BOP leads to currency appreciation.
A deficit in BOP leads to currency depreciation.
Focus:
Entire economic transactions (not just trade)
Includes capital flows, remittances, and reserves
Limitations:
Ignores the impact of speculation and government intervention
Assumes trade is the main driver, not capital flow (less realistic in modern economies)
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4. Asset Market Theory
Definition:
This theory considers exchange rates as determined by the supply and demand for financial assets (stocks, bonds, and currencies) rather than goods and services.
Focus:
Investor preferences, interest rates, risk, and expected returns on foreign assets.
Key Point:
Currencies are seen like assets — their value changes based on investors’ perception of profitability and safety.
Strength:
Explains short-term volatility in exchange rates better than PPP or BOP theory.
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5. Monetary Approach Theory
Definition:
This theory says exchange rates are determined by the relative supply and demand of money in two countries.
Implication:
If a country increases its money supply without a matching increase in output, its currency will depreciate.
A stable money supply supports a strong currency.
Assumptions:
Prices are flexible
Full employment exists
No capital controls
Limitations:
Overly theoretical
Less effective for short-term exchange rate prediction
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Conclusion
In practice, no single theory works perfectly, and a combination is often used to understand and predict exchange rate movements.
