Purchasing power parity (PPP)
Purchasing power parity, as set out by Cassel (1918), starts from the law of one price: the same good should cost the same everywhere. Absolute PPP holds that the exchange rate equals the ratio of the two countries' price levels, and relative PPP that the rate of change of the exchange rate equals the difference between their inflation rates. The Economist's Big Mac index is a simple illustration. Because of transport costs, tariffs and non-traded goods, however, PPP fits poorly in the short run, and Rogoff (1996) summarized studies finding that deviations from PPP take three to five years to halve.
Interest rate parity
- Covered interest parity (CIP): the interest differential between two countries equals the gap between the forward and spot rates (the forward premium or discount).
- Uncovered interest parity (UIP): the currency of the higher-interest country is expected to depreciate by the interest differential. In practice high-interest currencies often appreciate instead, which is known as the forward premium puzzle.
Balance of payments approach and the monetary model
The balance of payments approach explains the exchange rate through the demand for and supply of foreign exchange arising from the current and capital accounts. The monetary model, which appeared after floating rates began in the 1970s, combines PPP with the money demand function and holds that a country's currency depreciates when its money supply rises or its real income falls.
Dornbusch's overshooting model
Dornbusch (1976) noted that goods prices adjust slowly while asset markets and the exchange rate adjust immediately. When the money supply suddenly rises, interest rates fall; for interest parity to hold, the currency must be expected to appreciate in future, so the exchange rate depreciates by more than its long-run equilibrium and then gradually returns. The model explains why exchange rates are so volatile under floating regimes.
Empirical limits
Meese and Rogoff (1983) showed that structural models such as the monetary model do no better than a simple random walk in forecasting exchange rates one to twelve months ahead. Later research has also stressed that short-run exchange rates are driven largely by expectations, risk premiums and policy news, and fundamentals-based theories are mainly used to explain long-run direction.
References
- Cassel, G. (1918). Abnormal deviations in international exchanges. The Economic Journal, 28(112), 413-415.
- Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of Political Economy, 84(6), 1161-1176.
- Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out of sample? Journal of International Economics, 14(1-2), 3-24.
- Rogoff, K. (1996). The purchasing power parity puzzle. Journal of Economic Literature, 34(2), 647-668.
- Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics: Theory and Policy (11th ed.). Pearson.