Question

There are three theories that explain exchange rate behaviour, two of these deals with how inflation rates affect the exchange rate. They are purchasing power parity (PPP) and International Fisher Effect (IFE).

(a) In reality, PPP does not hold. Even PPP holds, this does not consistently occur. Give two major reasons why PPP does not hold consistently. Explain in detail.

(b) Assume the spot exchange rate of Singapore dollar to US dollar is US$0.7420/S$. The one-year interest rate is 0.3% in U.S. and 6% in Singapore. What would be the spot rate in one year according to IFE?

Answer 1

(a) There are a multitude of reasons why the concept of PPP does not hold in the real world. Before describing two such reasons it would be logical to mention that the PPP model is derived based on the "law of one price", which essentially states that similar goods should have equal prices across all markets all other things remaining same. In doing so the theory ignores such things as trade restrictions, differential taxation, transaction costs, transportation costs, capital control and more.

The first reason why PPP does not hold is the presence of transportation costs and trade restrictions in the world. Differential transportation costs coupled with various trade restrictions such as import tariffs, quotas, etc and geographical arbitrage opportunities lead to a divergence in prices of the same good in different markets.

The second reason for the failure of PPP is the restricted or imperfect flow of information across world markets. The PPP model assumes a perfect market with absolutely unrestricted information flow, thereby making price arbitrage opportunities an impossibility. However, in the real world, such arbitrage opportunities do exist, thereby again driving the prices of similar goods away from each other and disproving the principle of PPP.

(b) Current Exchange Rate = S = 0.742 $ / S $, US Interest Rate = 0.3 % and Singapore Interest Rate = 6 %

Therefore, as per IFE One Year Spot Rate = 0.742 x [1.003 / 1.06] = $ 0.7021 / S $