Theories of exchange rate (Purchasing power parity / Law of one price…
Theories of exchange rate
Purchasing power parity / Law of one price
OECD has a department
Divided as Absolute and Relative
Focuses on inflation-exchange rate relationship
Suggests that the price of similar products of two different countries should be equal, if they are measured in a common currency.
If there exists any difference, then the demand should shift from one country to another in such a way that the prices will have to converge.
Portfolio balance approach
assumes imperfect substitutability
assumes that domestic and foreign bonds are perfect substitutes
With sterilization, the monetary authorities can determine the money supply in the SR without having reserve flows offset their goal.
If there are barriers to international capital mobility, international asset return differential would persist.
The central bank can change the money supply growth in the SR without inflicting reserve flows
Traditional approach / Trade or elasticities approach
Based on flow of goods and services
Assumes an equilibrium exchange rate where the imports balance the exports of the country.
If at any point, imports exceed exports (trade deficit), then the exchange rate will fall, which in other words means that the domestic currency will depreciate.
Interest Rate Parity Theory IRP
This theory provides a linkage between the foreign exchange market and the international money markets.