- Theory Of Purchasing Power Parity (Ppp)
This theory was enunciated by Gustav Cassel. Purchasing power of a currency is
determined by the amount of goods and services that can be purchased with one unit of
that currency. If there is more than one currency, it is fair and equitable that the
exchange rate between these currencies provides the same purchasing power for each
currency. This referred to as purchasing power parity.
It is ideal if the existing exchange rate is in tune with this cardinal principle of purchasing
power parity. On the contrary, if the existing exchange rate is such that purchasing
power parity does not exist in economic terms, it is a situation of disequilibrium. It is
expected that the exchange rate between the two currencies conforms eventually to
purchasing power parity.
An index of exchange rate provides/indicates the mean rate of the country’s currency
with respect to the currencies of trade partners, weighted in terms of trade flows. The
index for a country is obtained by fi8nding the weighted average of bilateral exchange
rates of the country under study and its major trade partners. It indicates the extent by
which purchasing power of a currency has changed over the period/in the current year,
with respect to that of the base year. If exchange rate variations compensated exactly the
differential of inflation rates, the index would remain unchanged at 100. If an exchange
rate becomes stronger than what is justified by the rate of inflation (i.e., the index
becomes higher than 100), the exchange rate is considered as overvalued from the point
of view of competitively.
Conversely, if the index is less than 100, it is regarded undervalued from the point of
view of competitively.
The THEORY OF INTEREST RATE PARITY, states that premium or discount of
one currency against another should reflect the interest differential between the two
currencies. In a perfect market situation and where there is no restriction on the flow of
money, one should be able to gain the same real value on one’s monetary assets
irrespective of the country where they are held.
The theory of interest rate parity is a very useful reference for explaining the differential
between the spot and future exchange rate, and international movement of capital.
Deficit, in BOP increases the demand of foreign exchange. Surplus increases the value of
national currency on the exchange market.
The following methods are employed for the forecasting exchange rates.
1) Method of advanced indicators
2) Use of forward rate as a predictor of the future spot rate.