Theory of Exchange Rate Determination: PPP Approach

By: EconomyWatch   Date: 23 November 2010

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This paper focuses on the different theories used in the determination of exchange rates.

 
Purchasing Power Parity (PPP) Approach

The PPP Approach is based on the law of one price. According to this law, goods that are identical in nature should be sold at the same price. The implication of this law is that the exchange rates should change in response to the price differentials that exist between countries.

 
Stated mathematically,

Pt = Pt*/et
Where Pt is the domestic price for time period t
Pt* is the foreign price for time period t
et is the exchange rate for time period t

The main problem with the Purchasing Parity Approach in the determination of Exchange rates s that it does not hold true in the short or the medium term. But this is very much applicable in the long run.

 

Balance of Payments Approach

This approach determines the exchange rate at which both the internal and the external economy are in equilibrium. Internal equilibrium in the economy reflects a state of full employment whereas external equilibrium implies equilibrium in the balance of payment.

The lacuna of this theory is that it is difficult to determine an exchange rate in the short run that is consistent with the natural rate of unemployment or equilibrium in the balance of payments. The magnitude o this problem gets reduced in the long run.

 
Monetary and Portfolio Approach in the Determination of Exchange Rates

This approach is based on the assumption that economic agents can chose from a portfolio of domestic and foreign assets. The assets that can be in the form of money or bonds have an expected return. The arbitrage opportunity that is attached with this return determines the exchange rate.

The monetary or the portfolio approach also faces problem in its applicability in the short run.


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