Question

Explain how purchasing power parity and international Fisher effect are used to forecast future or forward currency exchange rates between two countries.

Answer 1

1]	Per the 'Purchasing Power Parity Theory', the forward rate is
	given by the formula:
	F = S*(1+ih)/(1+if), where
	F = the forward rate, S = the spot rate, ih = inflation rate in the
	home country and if = inflation rate in the foreign country whose
	currency is bought or sold.
	Thus, changes in exchange rate are dictated by the changes in price
	level in the two countries.
	The theory says that the ratio of price levels should be equal to the
	exchange rate between the two currencies. As a result, the a good
	or service must cost the same in both the countries if the exchange
	rate is accounted for.
	From the formula for the forward rate, it is evident that the
	current with higher inflation rate will depreciate in future and the
	currency with lower inflation rate will appreciate.
2]	The 'International Fisher Effect' postulates that differences in
	nominal interest rates in two currencies reflect expected changes
	in the spot exchange rate between the two currencies.
	Per the the theory, the future exchange rate is given by the formula:
	F = S*(1+rh)/(1+rf), where rh = nominal interest rate in the domestic
	country and rf = the nominal interest rate in the foreign country.
	This being so future exchange rate gets adjusted to the interest
	rate differential.
	The currency with the higher interest rate will depreciate and the
	currency with the lower interest rate will appreciate.