1. Purchasing Power Parity
There are three concepts of PPP that are employed by economists. On the most basic level, PPP states that identical goods should have exactly the same price irrespective the location of those goods. PPP tends to hold over the long-term. However, evidence supporting the long-term effectiveness of PPP as a predictor of exchange fluctuations is week.
- The Law of One Price
The law of one price states that identical goods should have the same price in all location.
- Absolute Purchasing Power Parity
Instead of focusing on individual products, absolute PPP compares the price of a basket of similar goods between two countries.
Absolute PPP = (Exchange Rate) x (Domestic Price/Foreign Price)
- Relative Purchasing Power Parity
While absolute PPP depends on the ratio of the level of prices in two countries, relative PPP depends on the ratio of the growth rates of the prices in the two countries. Hence, it is the rate of inflation that is critical here. Therefore, relative PPP require that the exchange rate be only proportional to the ratio of the two price indices.
2. Interest Rate Factors
The nominal risk-free rate of interest in a country can be derived from the real interest rate and the rate of expected inflation.
Nominal Rate = Real Rate + Expected Inflation
The nominal rate is the rate that you see quoted in the financial press on risk-free deposits. Interest rate differentials play a role in determining the exchange rate as will appreciate. However, this equation also only holds in the long run.
3. The Balance Of Payments
The Balance of Payments is the systematic account of all transactions in a given period between a country and the rest of the world.
- The Current Account
This is the account that holds all the transactions of imports and exports of goods and services for the country, its trade balance.
- The Financial Account
This account holds the transaction for the flow of capital for portfolio and direct investment purposes to and from a country. Balance of payment issues affect currency values but only over the longer term.
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