Question

1) Describe (by using a hypothetical example) the way the Purchasing Power Parity concept can be used to predict the direction and magnitude of long-term future exchange rate changes between two currencies. Provide all necessary calculations.

Answer 1

According to Relative Purchasing Power Parity Definition, Exchange rate between 2 countries will appreciate or depraeciate based on Interest rate differential between the 2 countries. This interest rate differential is sum of Real interest rate and Inflation rate.

For example, suppose the Spot rate between INR and USD is 75 INR for 1 USD. Current Interest rates in India are 8% while that in USA are 3%. There is an interest differential of 8% - 3% = 5%. Thus, Indian Rupee is expected to depreciate by 5% over 1 year period. i.e. Spot rate after 1 year will be 70 * (1+5%) = 73.5 INR i.e. 1 USD will now fetch 5% more INR.

As explained above, we can use PPP to predict the direction (country with higher interest rate differential between 2 countries will depreciate compared with country with lower interest rate) and the magnitude will be the interest rate differential (5% in above example).