Question

Recall the theories of purchasing power parity (PPP) and international Fisher effect (IFE) in Chapter 8. If these theories were used to forecast exchange rates, which techniques would they be classified? Why?

Answer 1

Answer:

Purchasing power parity (PPP)- This theory studies the different countries' currencies on the basis of some basket of goods. It allows you to buy same sort and amount of goods and services in every country. Government agencies use PPP to compare the output of different countries. As per this theory, two currencies are at equilibrium when prices of certain goods and services are same in both the countries taking into consideration the exchange rate.

World bank computes PPP of each country in the world. U.S.Dollar is the world's biggest currency. But all countries do not use U.S.Dollars. You will find McDonald's burger in USA at $5.28 while in China, you will get same at $3.20. Since labor, raw material and cost of living are cheaper in China that is why price of Burger is cheaper in China as compare to USA. The size and quantity of burger is same in both the countries but the price is different because of some economic factors. PPP solves this problem, if we use PPP then price of burger in China will be $5.04 and same in USA.

International Fisher effect (IFE)- This theory states that the difference between nominal interest rate in two countries is directly proportional to the changes in their exchange rate at a particular time. This theory was developed by Irving Fisher in USA. This theory is used to predict Spot and future currency movements. This theory is based on the assumption that interest rates are independent of other monetary variables. Inflation rate does not change real interest rate since the real interest rate is nominal rate minus inflation, country with lower interest rate will see lower inflation and vice versa.

Conclusion- If exchange rates are to forecast then PPP is should be used because PPP takes the actual exchange rates of the company into consideration.