Economic Theories of Exchange
Hello friends, welcome again to the class on International Business. So, this is somethinglike you know which always interests us and even challenges us what is the exchangerate and how exchange rate is determined.So, in the last few lectures, we have been discussing about them right what is exchangerate, what factors affect the exchange rate and why exchange rate is so important forinternational business.(Refer Slide Time: 00:56)And today in the last lecture also we discussed about the theories of exchange rate right,So, and when we talked about the theories of exchange rate, so the first theory we talkedabout was the purchasing power parity right.(Refer Slide Time: 00:58)So, in this theory, we talked about two conditions; one is the absolute PPP which is veryless dynamic right in comparison to the other one which is the relative PPP right and wetried to understand right.(Refer Slide Time: 01:23)So, continuing that, then we will have these two right. But let us continue with thepurchasing power parity. What is the use or advantage of the PPP? So, since you haveunderstood this, let us see so, what it does is it develops the PPP develops reasonablyvery accurate economic statistics right to compare the market conditions of differentcountries. First this is the basic advantage.For example, the PPP is often used to equalize calculations of GDP right. Becausepurchasing power can vary from country to country. I will show you an example now.The statistics for GDP based on purchase power purchasing power parity is oftendifferent than the nominal GDP right.So, GDP as described which is nominal as described by the currency exchange aloneright and second advantage is that the it compares the quality or standard of living indifferent countries which may not be possible if one just looks at the; looks at the percapita income. A lower income may allow a good quality of life in a country whereprices are low. So, that it will not have a much of any impact rather it the understandingwill be very different. So, let us; let us look at one case now.(Refer Slide Time: 02:40)How does India and Japan stand when it comes to PPP right? So, look let us read this.Under the regular method of GDP calculation, India’s economy is well behind Japan. So,the countries are United States, China, Japan, Germany, United Kingdom and India so,this is sources April 2018.You see in terms of nominal GDP, United States in 19.39 trillion, China 12.01, Japan4.87, Germany 3.68, United Kingdom 2.62 and India is just at the sixth point 2.61 trillionright. But does it remain the same when we look at the purchasing power parity? We willsee that right.So, however, price levels in Japan are much higher than that of India or in the US. So, ifyou buy something in India the same product, you may have to pay much higher incomparison to India.So, when the IMF adjust the national income of the two countries in terms of PPPexchange rate using US dollar. Indian economy was at 9.45 trillion this one right thiscondition in 2018 because of the lower prices while Japan stayed at 5.42 trillion. Now, ifyou look at this now ratio, India stands at what position 1, 2 and 3 so, the top countrybecomes China followed by United States and then India right.Essentially, it means that in total two countries have the same purchasing power, butbecause of its much lower population average Japanese is way ahead of average Indianin purchasing power right. So, basically what it helps you is to give a very realisticpicture of what is happening. So, in this case, India easily overtakes the Japan in terms ofPPP, but it has its own limitations also. PPP has limitations what is it?(Refer Slide Time: 04:39)So, the first limitation is this theory assumes that changes in price levels will bring inchanges in the exchange rate. What? Change in price level will bring in changes in theexchange rate, but not vice versa.That means, change in exchange rate brings in what kind of effect on price that is notknown right. So, that is changes in exchange rate cannot affect domestic price levels ofthe countries concerned. So, this is an assumption which might not be true right.Similarly, according to the theory to calculate the new equilibrium rate one must knowthe base rate. So, we are comparing as per the base rate. So, that is the old equilibriumrate, but as you have understood by now so, it depends on so many factors how do youdecide that base rate right.But it is difficult to ascertain the particular rate which actually prevailed between thecurrencies as the equilibrium rate. So, that rate to actually find out because it is sodynamic. It is every minute, every second it is changing. So, to exactly ascertain to findit is very very complex task. So, some assumptions have to be made right.Third, it assumes away transportation costs and barriers to trade. Now that is only a veryhypothetical situation. In practice, these factors are significant and they tend to createsignificant price differential between countries right. So, what kind of trade barriers arethere, what kind of transportation costs they will entirely change the price right whichagain will have an effect on the exchange rates.Finally, the governments regularly intervene in the foreign exchange market right andthis further weakens the link between price changes and changes in exchange rate. Now,that is we know that the government tries to intervene to you know make the trade in itsfavor. So, these conditions will always create a disruption right and it further weakensthe link between price and changes in exchange rate. So, these are some of thelimitations of the PPP theory right.(Refer Slide Time: 06:59)Now, we will look at some important terms before moving further right. So, one is thespot market and the forward market. Spot market you just have understood now beforewe were talking about spot right something on the spot. In the spot market, the deliveryof the foreign exchange has to be made right on the spot. Usually, within 2 days of thetransaction. So, that means, any transaction is being made the delivery has to be madeimmediately.The exchange rate at which the transaction takes place is called the spot rate. So,whatever the exchange rate with at that point of time is called the spot rate. The spotexchange rate is determined by immediate market demand and supply of the foreignexchange. So, what is the at the moment so, it is so dynamic. So, what is the currentmoment at which I am let us say exchanging.So, I am going to let us say buy some dollars because I am going abroad. So, when I amgoing abroad, and I am buying what is the current value at that point time of time iscalled the spot exchange rate.But during business, while doing business, many a times we need some extra time periodright. So, for that came the comes the forward market. Now what is the forward market?It says the foreign exchange is bought and sold for delivery at a future date at an agreedrate today. That means, we have agreed for a rate today which we will pay later on this iscalled as a forward contract.The rate at which the forward exchange contract is agreed is called the forward rate right.Now why it is done? You must have heard the word hedging. Sometimes, it is importantthat we do not, we cannot exactly find out what will happen to the you know values. So,it may go up, it may go down. So, in order to avoid a loss in such situations, it might be aprofit also, but if it is a loss it is more dangerous for us right. So, we will go for a moresafer side. So, to do that we use this forward rates.It is used to insure against unfavorable changes in the exchange rate. If it is a favorableexchange rate everybody will be happy, but what if it is an unfavorable the entirebusiness may go bankrupt. So, to ensure this is done. The usual forward exchange rate issigned for 1 month, 3 months, 6 months, 9 months which is most common right. Let uslook at this.I could enter into an agreement today to purchase 100 euros three months from today.So, I have made a contract, I have made a agreement that I will purchase 100 euros at aprice this that 1 euro is 1.101; 1.01 dollars right I have agreed to buy at this price. Notethat, no currencies are paid out at that time. So, today I am not paying, today as this dateI am not paying any amount, the contract is signed except for 10 percent maybe securitymargin ok.After 3 months, I get 100 euros for 101 dollars, so this is it. Regardless of what the spotrate is at that particular time. Maybe the spot rate is actually come down to 0.99 or it hasgone up to 1 euro is dollar is now 0.99 or it is 1.02 whatever. So, I am not concernednow ok.(Refer Slide Time: 10:28)So, this is we will use now these words that is why we did it. So, now, coming to thesecond theory right, the second theory in exchange rates is called the interest rate paritytheory. Now what is this interest rate parity? It is a very interesting. So, this theory saysthat the interest rate differential between two countries is equal to the differentialbetween the forward exchange rate and the spot exchange rate. Let us go back andunderstand.What it says? IRP is a theory in which the interest rate differential, interest ratedifferential means the difference between two countries A and B right is equal theinterest rate difference is equal to the difference between the forward exchange rate;forward rate and the spot rate this is what it says right. Forward exchange rates forcurrencies are exchange rates at a future point in time, as opposed to the spot exchangerate which are current, we have already learnt it.It plays a very crucial role in the forex markets right because of its you know favourableand unfavorable situations or the extreme change dynamism right. The interest rate paritypresents an idea that there is no arbitrage in the foreign exchange markets right. Itpresents an idea that there is no arbitrage right.(Refer Slide Time: 11:58)So, the formula for the interest rate parity is something like this. So, what it says,forward rate divided by spot rate is equal to interest rate in country A right by interestrate in country B right. So, this is you have to remember.Now let us see this. Suppose the borrowed amount is 100000 dollars ok. Interest rateprevailing in India is how much? Let us say 12 percent. Interest rate prevailing in US is 7percent ok. So, when you see this difference, what comes to your mind like anybody whois does business, you will think there is a difference so, why not take advantage of it.So, anyone who try to take advantage of the situation. So, by borrowing in US at 7percent per annum, I take extra loan right at 7 percent per annum and I would invest inIndia 12 percent per annum simple right.Thereby, earning the net differential interest of 5 percent this is very much theoreticallypossible. But essentially, this is not so simple. It does not happen that way. Now, why itdoes not happen? Theoretically we are seeing it is happening. So, let us see why it is nothappening.(Refer Slide Time: 13:12)In fact, as per the interest rate parity theory, this is not possible right why? The exchangerate between rupees and dollar would have changed adversely in such a way that theinterest rate differential so earned shall be compensated by the exchange loss arising onrepayment of the US loan this is US; US loan right. So, he had taken loan from USmarket right at 7 percent. So, let us extend the above example.Assume the spot rate is 64 rupees = 1 dollar right. So, somebody now would take a loanat 7 percent from US so, hypothetical now. So, the resulting gain is he takes a loan of100000 which is 64 rupees in India, and he gets a 5 percent advantage. So, how much isthe advantage 320000 rupees right, this is rupees 320000.Now, let us determine the 1 year forward rate. So, what is it? Now Fo is equal to look atthis from here only. So, Fo = So * 1 + interest rate + interest rate in the B country. So,how much it is becoming? So, 64 * 1 + in India interest rate in India is how much? 0.12and this is 0.7; 07. So, this value actually now becomes how much? Now this becomesso, the forward rate is now 66.9907.(Refer Slide Time: 14:55)Now, what is happening because let us take this total in totality. So, the amountborrowed is this much, interest paid is 7000 dollars right 7000 dollars; obviously, 7percent in the US market. So, total amount payable is this much at the end of the year.Amount payable as per spot rate prevailing at the beginning is how much? He wouldhave paid 1 lakh 7 * 64 right so, in Indian rupees it is this much ok. Total amountpayable at the end year end is how much? Now the it has changed so, 1 lakh 7 * thismuch. So, 7168000. Now, the excess payable due to the this difference right thisdifference = 3 lakh 20.So, now that means, what has happened? Whatever the benefit you would have got hasbeen all lost or compensated by this increase in value right. So, as per interest rate parity,the resulting exchange loss has completely offset the gain made through interest ratedifferential. So, this is what it says ok.(Refer Slide Time: 16:02)Now what are the implication? If this difference is positive, forward rate minus spot rateso, Fo minus So right it is known as a forward premium. A negative difference is termedas forward discount right. If IRP theory holds then, arbitrage is not possible; it is notpossible. No matter whether an investor invests in domestic country or foreign country,arbitrage is not possible, and you know arbitrage the difference basically. The rate ofreturn will be the same as if an investor invested in the home country when measured indomestic currency it says.If domestic interest rates are less; if domestic interest rates are less; that means, theIndian for example, then foreign interest rates, foreign currency must trade at a forwarddiscount to offset any benefit of higher interest rates in foreign currency to preventarbitrage.So, what is happening? If foreign currency does not trade at a forward discount which itis right or if the forward discount is not large enough to offset the interest rate advantagearbitrage opportunity would exist for domestic investors. So, domestic investors canbenefit by investing in the foreign market in that condition.So, if the forward rate is above the present spot rate, foreign currency is said to beforward premium we have said this because this is the same you know. So, theseconditions are so volatile and so dynamic that sometimes they compensate for each otherright and at the end, the gain is to be very it has to be to calculate this gain is verydifficult also right.(Refer Slide Time: 17:48)If domestic interest rates are more. So, what happened here domestic interest rates wereless. So, there was an arbitrage opportunity. If domestic interest rates are more than theforeign; that means, in India it is more than US, foreign currency must trade at a forwardthis forward premium right to offset any benefit of higher interest rates in the domesticcountry to prevent arbitrage.If foreign currency does not trade at a forward premium or if the forward premium is notlarge enough to offset the interest rate advantage of the domestic country, arbitrageopportunity exists for the foreign investors. So, what happens? The foreign investorsnow can benefit by dominating in the investing market in the domestic market.So, could you understand? So, depending on the how much is the difference and what isthe interest rate if this is close, then it is a state of equilibrium. If one is more than theother, then there is an opportunity for arbitrage that exists, and the price differentialwould be taken up by the domestic or the foreign investor ok.What is the limitation? In many countries with higher interest rates right often experienceit is currency appreciation or appreciate the currency appreciate due to higher demandsand higher yields and has nothing to do with riskless arbitrage right.So, because of the higher interest rate, that the currency demand is going. So, theappreciation is happening right. So, because of the higher demand and higher yield andnot due to the arbitrage which is generally thought off right.(Refer Slide Time: 19:26)The third exchange rate study is through the Fisher effect. So, this is an economic theorycreated by Irving Fisher that describes the relationship between inflation and both realand nominal interest rate. This is also interesting, very interesting. So, according to theFisher effect, what is it saying? The real interest rate is equal to the nominal interest rateminus the expected rate of inflation. So, what it is saying? r = nominal interest rate or iright so, i - pi is inflation basically is shown as inflation.Real interest rate adjusts the observed market interest rate for the effects of inflation andtakes purchasing power into account. So, what is it doing? The real interest rate adjustfor the inflation effect and takes the purchasing power into account. The nominal interestrate does not do that. It refers to the interest rate before taking inflation into account. So,it does not take the inflation. So, what is the Fisher equation saying? So, real interest rate= nominal interest rate - inflation rate, r = i - pi.(Refer Slide Time: 20:43)So, he gave his theorem which says that 1 + nominal rate = 1 + real rate * 1 + inflationrate this is the Fisher theorem. So, 1 + i = 1 + r * 1 + pi right. So, the result in practice isthat as inflation rates go up so, this is inflation real interest rate go down right.So, in order to when nominal rates do not increase at rates equals equal to those ofinflation to in order to keep this constant so, if this increases, so this has to come downobvious right. This effect is always, not always immediately visible, but over time it is aconsistent economic pattern. So, this is very important, we will see in the example in thenext slide. So, what it is saying that the nominal interest rate = the real is affected by thereal and the inflation real interest rate right.(Refer Slide Time: 21:47)So, the real interest rate obviously, there is their equation, so they affect each other.Suppose let us say this example. Suppose you own a firm having the real rate of return to3.5 percent right and expected inflation to 5.4. So, what is it saying? The real rate ofreturn is 3.5 and the expected inflation is 5.4.So, according to the above formula what happens? The approximate nominal rate ofreturn can be calculated as how much now 0.035 + 0.054 by normally if you go by it,then it should be 0.089 so, the real rate of return + the inflation right so, = 8.9.Substituting the value of i and r in the formula in this formula, now you will see thatwhat is happening? So, 1 + r so, 1 + r * 1 + pi now that makes if you multiply these twoso, that would actually give you the nominal interest rate as 9.1 and not 8.9 right.So, what it is saying basically? The Fisher equation is saying that therefore, theapproximate relationship between the real interest rate and the nominal interest rate canbe shown as follows what is it? Now, i the nominal interest rate is approximately = r +the pi r plus pi here pi right. So, r plus pi so, real plus pi. So, now what are theimplications right.(Refer Slide Time: 23:24)So, when the nominal interest rate tend to run parallel to inflation; when the nominalinterest rate runs parallel to the inflation rates so that, monetary policies effectivelyneutralized due to the Fisher effect. Re-read and think about it. More specifically, whenthe money supply is increased by a central bank let us say the RBI.If the RBI is increasing the money supply and expected inflation rises so, the inflationtend would tend to rise, that central bank also increases the interest rates. So, whenmoney supply is increased, the central bank by central bank expected inflation rises, thatcentral bank also will increase the interest rates. Now, when nominal interest ratesincrease simultaneously with inflation rates; that means, that there is little practicaleffect. So, the practical effect is negligible.The Fisher effect is an important tool by which lenders can find whether or not they aremaking money on a granted loan. So, are you really making money? So, the Fisher effectcan help you in finding out. Moreover, according to the Fisher’s theory, even if a loan isgranted at no interest let us say no interest, a lending party would need to charge at leastthe inflation rate in order to retain the purchasing power upon repayment right. So, this iswhat the Fisher theory talks about right.(Refer Slide Time: 24:55)So, international Fisher effect now. There is another you know view to that what is itsaying? The Fisher effect shows that for a given real rate, the higher the expectedinflation rate, the higher the nominal rate. Now international Fisher effect extends thisconcept to the nominal rates in two countries. Now what is it saying?Countries with higher nominal rate have higher inflation rates due to the Fisher effectright. Now using relative purchasing power parity where the change in the exchange rateshould be related to the differences in inflation rates of two countries.Now what it is saying? Using relative purchasing power parity where the change in theexchange rate should be related to the differences in inflation rates of two countries.Here, international Fisher effect says that the change in the exchange rate should berelated to differences in the nominal rates of the two countries. So, this is what the IFEsays right.(Refer Slide Time: 25:58)Now equation look something like this. So, this is how the equation looks like this. So,expected change in the exchange rate right is equal to 1 + nominal rate in the homecountry by nominal rate 1 + nominal rate in the foreign country and - 1 and this isapproximately equal to the same right again.(Refer Slide Time: 26:19)Suppose the nominal rate interest rate on a one-year insurance US bank deposit is 9percent take this example and the rate on one-year insured British bank deposit is 10. So,this is 9, this is 10. What does IFE predict will happen to the exchange rate right? So, ifyou look at it so, this is the let us go back to the formula. So, i h home and foreign right.So, when you do this; this; this is the final value which is coming.So, what it is saying the solution? The British pound to depreciate by little less than 1percent. Implications of the international Fisher effect it suggests that currencies withhigher interest rates will have high expected inflation due to the Fisher effect and therelatively the high inflation will cause the currencies to depreciate due to the purchasingpower parity effect right.So, this is all we have for today. So, I these are the three different methods throughwhich you can find the exchange rate and you can, if you start solving little moreproblems and you know work on this.You will find finally, get a connect between how these different parameters areconnected to each other and then only one can be a good adviser to somebody to andmaybe suggest what should be the you know future agenda, future strategy or policy fora company or a for a nation or for even an individual, how it should you know look at thebenefits that it can make by understanding this different scenarios right.So, this is all we have for the day. Thank you very much. We will meet in the nextlecture right.Thank you.