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Using four way equivalence explain the relationship between inflation rates interest rates and excha

This pages looks at the main determinants of exchange rates, whether or not they can be predicted and with what level of certainty.

  1. The main exchange rate systems include. PPPT predicts that the country with the higher inflation will be subject to a depreciation of its currency.
  2. Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate. According to interest rate parity theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate.
  3. Fixed exchange rates This involves publishing the target parity against a single currency or a basket of currencies , and a commitment to use monetary policy interest rates and official reserves of foreign exchange to hold the actual spot rate within some trading band around this target.
  4. Capital movements between economies There are also capital movements between economies.
  5. The basket is often devised to reflect the major trading links of the country concerned. To hold sterling above this rate in 1992, the government used a significant amount of the UK's foreign currency reserves and a high interest rate policy.

Why exchange rates fluctuate Changes in exchange rates result from changes in the demand for and supply of the currency. These changes may occur for a variety of reasons, e. Balance of payments Since currencies are required to finance international trade,changes in trade may lead to changes in exchange rates.

  • Several factors may lead to inflows or outflows of capital;
  • Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate;
  • The general conclusion from early studies was that forward rates are unbiased predictors of future spot rates;
  • If you need to estimate the expected future spot rates, simply apply the following formula;
  • Forward Rates and Expected Future Spot Rates Our current understanding of the workings of the foreign exchange market suggests that under a system of freely floating rates, both the spot rate and the forward rate are influenced heavily by current expectations of future events, and both rates move in tandem, with the link between them based on interest differentials;
  • Fixed against a single currency This is where a country fixes its exchange rate against the currency of another country's currency.

Thus a country with a current account deficit where imports exceed exports may expect to see its exchange rate depreciate, since the supply of the currency imports will exceed the demand for the currency exports. Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate. Capital movements between economies There are also capital movements between economies.

Purchasing Power Parity

These transactions are effectively switching bank deposits from one currency to another. These flows are now more important than the volume of trade in goods and services. Several factors may lead to inflows or outflows of capital: These forces which affect the demand and supply of currencies and hence exchange rates have been incorporated into a number of formal models.

Exchange rate systems Although the world's leading trading currencies, like the US dollar, Japanese yen, British pound and European Euro are floating against the other currencies, a minority of countries use floating exchange rates.

The main exchange rate systems include: Fixed exchange rates This involves publishing the target parity against a single currency or a basket of currenciesand a commitment to use monetary policy interest rates and official reserves of foreign exchange to hold the actual spot rate within some trading band around this target.

Fixed against a single currency This is where a country fixes its exchange rate against the currency of another country's currency. More than 50 countries fix their rates in this way, mostly against the US dollar. Fixed rates are not permanently fixed and periodic revaluations and devaluations occur when the economic fundamentals of the country concerned strongly diverge e.

Fixed against a basket of currencies Using a basket of currencies is aimed at fixing the exchange rate against a more stable currency base than would occur with a single currency fix. The basket is often devised to reflect the major trading links of the country concerned.

Predicting Exchange Rates

British pound previously used a fixed rate system The pound was fixed against the US dollar from 1945 to 1972, and more recently was part of the European Exchange Rate Mechanism ERM between 1990 and 1992. To hold sterling above this rate in 1992, the government used a significant amount of the UK's foreign currency reserves and a high interest rate policy. Freely floating exchange rates sometimes called a clean float A genuine free float would involve leaving exchange rates entirely to the vagaries of supply and demand on the foreign exchange markets,and neither intervening on the market using official reserves of foreign exchange nor taking exchange rates into account when making interest rate decisions.

The Monetary Policy Committee of the Bank of England clearly takes account of the external value of sterling in its decision-making process, so that although the pound is no longer in a fixed exchange rate system, it would not be correct to argue that it is on a genuinely free float.

Managed floating exchange rates sometimes called a dirty float The central bank of countries using a managed float will attempt to keep currency relationships within a predetermined range of values not usually publicly announcedand will often intervene in the foreign exchange markets by buying or selling their currency to remain within the range. PPPT is based on 'the law of one price', which states that in equilibrium, identical goods must cost the same, regardless of the currency in which they are sold.

PPPT predicts that the country with the higher inflation will be subject to a depreciation of its currency. If you need to estimate the expected future spot rates, simply apply the following formula:

  • New information, such as a change in interest rate differentials, is reflected almost immediately in both the spot and forward rates;
  • At this point, there is no longer any incentive to buy or sell the currency forward.