PRICES AND EXCHANGE RATES

MANVESHBIR SINGH
HARDEEP SINGH
PAWANDEEP KAUR

The relationship between exchange rates and prices starts

with a very basic idea ANY PRODUCT SHOULD COST THE
SAME EVERYWHERE.
Suppose that a BMW sells for
$40,000 in the United States and
E 30,000 in Germany. The
current exchange rate is $1.25
per Euro.

Borrow $37,500 and convert

it to Euros at $1.25/Euro.

Buy a BMW in Germany for

E30,000 and ship it back to
the US.
Sell the car in the US for
$40,000

$37,50
=E
0$1.2
30,000
5

P eP* ($40,000 $37,500) $2,500

A 6.7%
return

THE LAW OF ONE PRICE

Law of one price

Identical goods sold in different countries must

sell for the same price when their prices are
expressed in terms of the same currency.
This law applies only in competitive markets
free of transport costs and official barriers to
trade.
Example: If the dollar/pound exchange rate
is $1.50 per pound, a sweater that sells for
$45 in New York must sell for 30 in
London.

PURCHASING POWER PARITY (PPP)

The ratio between domestic and
foreign price levels should equal the
equilibrium exchange rate between
domestic and foreign currencies.
$1 = loaf of bread
$1 = 0.6475
0.6475 = loaf of bread

EMPIRICAL TESTING OF PPP

Empirical testing of PPP and the law of one price
has been done, but has not proved PPP to be
accurate in predicting future exchange rates.
Two general conclusions can be made from these
tests:
PPP holds up well over the very long run but
poorly for shorter time periods
The theory holds better for countries with
relatively high rates of inflation and
underdeveloped capital markets

INTEREST RATES
AND EXCHANGE RATES
The Fisher Effect states that nominal interest rates
in each country are equal to the required real rate
of return plus compensation for expected inflation.
This equation reduces to (in approximate form):
i=r+
Where i = nominal interest rate, r = real interest
rate and = expected inflation.
Empirical tests (using ex-post) national inflation
rates have shown the Fisher effect usually exists
for short-maturity government securities (treasury
bills and notes).

INTEREST RATES
AND EXCHANGE RATES
The relationship between the percentage
change in the spot exchange rate over time
and the differential between comparable
interest rates in different national capital
markets is known as the international Fisher
effect.
Fisher-open, as it is termed, states that the
spot exchange rate should change in an equal
amount but in the opposite direction to the
difference in interest rates between two
countries.

WHAT
DOESINTERNATIONAL
FISHER EFFECT IFEMEAN?

An economic theory thatstates thatan expected change in

thecurrent
exchange
rate
between
any
twocurrenciesis
approximately equivalent tothe difference between the two
countries' nominal interest rates for thattime.
For example, if country A's interest rate is 10% and country B's
interest rate is 5%, country B's currency should appreciate roughly
5% compared to country A's currency.
The rational for the IFE is that a country with a higher interest rate
will also tend to have a higher inflation rate. This increased amount
of inflation should cause the currency in thecountry with thehigh
interest rate to depreciate against a country with lower interest
rates.

INVESTOR PSYCHOLOGY AND BANDWAGON

EFFECTS
Evidence suggests that neither PPP nor the
International Fisher Effect are good at
explaining short term movements in
exchange rates.
Explanation may be investor psychology and
the bandwagon effect.
Studies suggest they play a major role in
short term movements.
Hard to predict.