What is the name of the theory in economics that governs exchange rates?
5.3. The purchase power parity (PPP) theory states that the exchange rates between currencies of two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services.
According to this theory, rate of exchange between two countries depends upon the relative purchasing power of their respective currencies. Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs.
Exchange theory is defined as a sociological perspective that views value as a product of consumer judgments rather than inherent in objects, emphasizing that purposive actors engage in exchanges based on their preferences, realistic expectations, and perceived benefits from transactions.
The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates.
What is Purchasing Power Parity? Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.
What are the three theories of exchange rate determination?
Table 9.1 compares three related theories of international finance, namely (i) Interest Rate Parity (IRP) (ii) Purchasing Power Parity (PPP) and (iii) the International Fisher Effect (IFE). All three theories relate to the determination of exchange rates.
GDP comparisons using PPP are arguably more useful than those using nominal GDP when assessing the domestic market of a state because PPP takes into account the relative cost of local goods, services and inflation rates of the country, rather than using international market exchange rates, which may distort the real ...
The UIP relation postulates that the interest differential between two countries should equal the expected exchange rate change. As such, a regression of exchange rate returns on the interest differential should give an intercept of zero and a slope coefficient of unity.
The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output).
What is the difference between IRP and PPP? IRP (interest rate parity is based on the spot and forward exchange rates, while PPP (Purchasing Power Parity) considers just the spot price.
Social exchange theory can also be called rational choice theory. The latter applies to broader situations than just personal relationships, such as economic or political behaviors within a society.
Locard's exchange principle is a foundational concept in forensic science, stating that whenever two objects come into contact, each leaves behind some trace or residue on the other.
What the foreign exchange model illustrates. Exchange rates are determined by the interaction of people who want to trade in their currency (the supply of a currency) with other people who want to obtain that currency (the demand for a currency).
According to the BOP theory of exchange rates, the supply and demand for a currency arise from the flows related to the BOP, that is, trade in goods and services, portfolio investment, and direct investment. Equilibrium exchange rates are determined when the BOP is in equilibrium.
The International Fisher Effect (IFE) states that the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time. Irving Fisher, a U.S. economist, developed the theory.
What is the gold standard theory of exchange rate determination?
The gold standard was also an international standard determining the value of a country's currency in terms of other countries' currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed.
Edgeworth model. Edgeworth's model follows Bertrand's hypothesis, where each seller assumes that the price of its competitor, not its output, remains constant. Suppose there are two sellers, A and B, facing the same demand curve in the market.
The Mundell-Fleming trilemma was developed in the 1960s, highlighting the complex relationship between exchange rates, capital flows, and monetary policy. The eurozone and the Bretton Woods Agreement serve as real-world examples of how countries navigate the trilemma's trade-offs.
The Harrod–Domar model is a Keynesian model of economic growth. It is used in development economics to explain an economy's growth rate in terms of the level of saving and of capital. It suggests that there is no natural reason for an economy to have balanced growth. The model was developed independently by Roy F.
The Fisher effect is a theory describing the relationship between real and nominal interest rates, and inflation. The theory states that the nominal rate will adjust to reflect the changes in the inflation rate in order for products and lending avenues to remain competitive.
Investors making use of CIP can use forward or futures contracts to cover exchange rates to hedge their market risk. Uncovered interest rate parity (UIP) involves forecasting rates and not covering exposure to foreign exchange risk. There are no forward rate contracts, and it uses only the expected spot rate.
Phillips's “curve” represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. Economists soon estimated Phillips curves for most developed economies.
The mint parity theory explains how exchange rates between countries on the gold standard were determined. Under this system, currencies were defined by and convertible to a fixed quantity of gold.
Advantages of PPP: A main one is that PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile, and using them could produce quite large swings in aggregate measures of growth even when growth rates in individual countries are stable.
However, relying on nominal GDP as a measure of production has limitations, as it may give a misleading impression of growth, merely reflecting price increases. Real GDP, on the other hand, accounts for changes in prices, providing a more accurate measure of actual output.
