Question

Analyze the main factors affecting exchange rates. In your answer refer to PPP and interest rate parity.

Answer 1

Purchasing Power Parity (PPP) is the theory that states that if the purchasing power of two countries is same then the exchange rate between the two countries will be in equilibrium.

Interest Rate Parity (IRP) is the theory that states that difference between the forward rate and spot rate of two countries is equal to the difference between the interest rates of the two countries.

The factors that affect the exchange rate are:

Interest rate: An increase in the interest rate leads to appreciation of the value of the currency.

Inflation rate: The low inflation rate in the country implies appreciation in the value of the currency. The high inflation rate on the other hand, leads to depreciation of the value of currency.

Political stability of the country and economic performance of the country are some other factors that influence exchange rates.