Question

Analyze the main factors affecting exchange rates. In your answer refer to PPP and interest rate parity.

Answer 1

Main factors affecting exchange rates:

• The rate of inflation and exchange rate
• Purchasing power parity
• Interest rates and exchange rates.
• Interest rate parity.
• Relative price levels

PPP(Purchasing power parity) : The exchange between the two national currencies is allowed to adjust freely if no restrictions are imposed and with the further assumption that costs of transport of goods between the countries are nil, then the exchange rate between the two currencies will reflect the differences in the price levels in the two countries.

It is noted that only in the long run and with no restrictions on the trade between the two countries that relative price level in the two countries will be reflected in the ex­changes rate.

IRP(Interest rate parity) : It is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. it plays an essential role in the foreign exchange market, connecting interest rates, spot exchange rates, and foreign exchange rates.