Week 6: Factors Affecting Exchange Rates & Purchasing Power Parity (PPP) Theory

Learning Objectives

By the end of this session, students will be able to:

4-Hour Session Planner

This session balances theoretical exposition with substantial numerical problem-solving. Faculty should reserve at least 45 minutes for guided and independent numerical work.

1. The Demand and Supply Framework for Foreign Exchange

1.1 Who Demands Rupees? Who Supplies Rupees?

The foreign exchange market, like any market, is driven by the interaction of demand and supply. The exchange rate — INR 83 per USD — is the price at which the demand for rupees equals the supply of rupees. Every international transaction recorded in India's BOP generates either a demand for rupees (someone needs INR to pay for Indian goods, services, or assets) or a supply of rupees (someone has INR and wants to convert them into foreign currency to pay for foreign goods, services, or assets).

The Exchange Rate as the Equilibrating Price: When the total demand for INR (from all sources — exports, remittances, FDI, FPI, ECBs) exceeds the total supply of INR (from imports, investment income outflows, outward FDI, FPI outflows, ECB repayments), the rupee appreciates. When supply exceeds demand, the rupee depreciates. The exchange rate moves continuously to balance the two sides. For the financial manager, the art of exchange rate forecasting is the art of anticipating which of these forces will strengthen or weaken — and by how much.

2. Fundamental Factors Affecting Exchange Rates

Exchange rates are driven by a complex interaction of economic, financial, and political forces. While no single factor explains exchange rate movements at all times, the following seven factors are the most systematically important. The financial manager must understand each — not as a mechanical predictor, but as a source of pressure whose strength varies with economic conditions and market sentiment.

2.1 Inflation Differentials

Mechanism: Higher domestic inflation relative to foreign inflation erodes the purchasing power of the domestic currency. Domestic goods become more expensive relative to foreign goods, reducing export demand and increasing import demand. The trade balance deteriorates, increasing the supply of the domestic currency (to pay for imports) relative to demand (from exports). The currency depreciates.

Direction: Higher domestic inflation → depreciation pressure. Lower domestic inflation → appreciation pressure.

Indian Context: India has consistently had higher inflation than the United States — averaging approximately 6–7% versus 2–3% over the past three decades. This persistent inflation differential is the single most important structural driver of the rupee's long-term depreciation against the USD — from INR 17.5/USD in 1991 to INR 83/USD in 2024. Relative PPP, which we study in Section 3, formalises this relationship: the expected depreciation should equal the expected inflation differential.

2.2 Interest Rate Differentials

Mechanism: Higher domestic interest rates (relative to foreign rates) attract capital inflows — foreign investors buy domestic bonds to capture the higher yield, creating demand for the domestic currency. This is the carry trade logic: investors borrow in low-interest-rate currencies (JPY, CHF) and invest in high-interest-rate currencies (INR, BRL, TRY), profiting from the interest differential — as long as the high-interest-rate currency does not depreciate by more than the interest gain.

Direction: Higher domestic interest rates → capital inflows → appreciation pressure (in the short run). Lower domestic rates → capital outflows → depreciation pressure.

Important Nuance: The interest-rate effect on the exchange rate is time-dependent. In the short run, higher rates attract capital and appreciate the currency (the "liquidity effect"). But higher rates also slow the economy and reduce inflation — which, over the medium term, leads to depreciation (if rates are cut in response to the slowdown). The financial manager must distinguish between the short-term (carry-trade) effect and the medium-term (real-economy) effect of interest rate changes. This distinction is formalised in the International Fisher Effect (Week 7).

2.3 Income Levels and Economic Growth

Mechanism: Faster domestic income growth increases demand for imports (both consumer goods — as households become wealthier — and capital goods — as firms invest to expand capacity). Import demand rises with income (the marginal propensity to import). If export growth does not keep pace, the trade balance deteriorates, and the currency faces depreciation pressure. Conversely, if income growth is driven by export expansion (as in East Asian economies), the net effect on the trade balance — and therefore on the exchange rate — depends on the relative strength of the export and import effects.

Direction: Faster domestic growth relative to trading partners → typically depreciation pressure (via import demand). But the effect is ambiguous if growth is export-led.

2.4 Government Controls and Central Bank Intervention

Mechanism: Governments and central banks can influence the exchange rate through: (a) direct intervention in the FX market (buying/selling foreign currency), (b) capital controls (restricting cross-border capital flows), (c) trade policy (tariffs, quotas affecting import demand), (d) exchange rate policy (devaluation/revaluation of a peg), and (e) moral suasion (encouraging or pressuring banks and firms to transact in ways that support the currency).

Indian Context: The RBI's managed float — and its asymmetric intervention pattern (buying USD to prevent appreciation, selling USD to smooth depreciation) — directly shapes the rupee's trajectory. The financial manager must assess not just the economic fundamentals that would determine the exchange rate in a free market, but the RBI's reaction function — how the central bank is likely to respond to exchange rate movements given its inflation target, growth objectives, and reserve adequacy.

2.5 Market Expectations and Speculation

Mechanism: Exchange rates are forward-looking asset prices — they reflect not just current conditions but market participants' expectations of future conditions. If the market expects the RBI to raise interest rates, the rupee may appreciate before the rate hike occurs — as speculators buy INR in anticipation. If the market expects a widening CAD, the rupee may depreciate before the trade data is released — as speculators short the INR. Expectations can be self-fulfilling: if enough market participants believe the rupee will depreciate, their collective selling of INR causes exactly the depreciation they anticipated.

Direction: Expectations of future appreciation → current appreciation. Expectations of future depreciation → current depreciation. The exchange rate is, in this sense, an "asset price" — it jumps in response to news that changes expectations, even before the underlying economic variable has changed.

2.6 Political Stability and Economic Performance

Mechanism: Political instability — elections with uncertain outcomes, policy unpredictability, social unrest, geopolitical tensions — increases the risk premium investors demand to hold the country's assets. The higher perceived risk drives capital outflows (or deters inflows), depreciating the currency. Conversely, credible economic reforms, political stability, and improved governance attract capital and strengthen the currency. The mechanism operates through the capital account (portfolio and FDI flows) and, in the extreme, through capital flight (residents themselves converting domestic currency into foreign assets to protect wealth).

2.7 Terms of Trade and Productivity

Mechanism — Terms of Trade: The terms of trade are the ratio of a country's export prices to its import prices. An improvement in the terms of trade (export prices rising relative to import prices) increases the country's export revenue relative to its import spending, improving the trade balance and strengthening the currency. A deterioration has the opposite effect. For India, a rise in global crude oil prices is a terms-of-trade deterioration (India imports oil and its price rises relative to India's export prices), which depreciates the rupee.

Mechanism — Productivity: Faster productivity growth in the tradable sector (the Balassa-Samuelson effect) raises wages in the tradable sector, which spill over into higher wages in the non-tradable sector. Since non-tradable productivity grows more slowly, non-tradable prices rise — this is domestic inflation that is not caused by monetary expansion but by productivity differentials between sectors. The result is a real exchange rate appreciation — the Balassa-Samuelson effect explains why currencies of fast-growing economies tend to appreciate in real terms over time, even as they may depreciate in nominal terms due to inflation.

3. Purchasing Power Parity (PPP) Theory

Purchasing Power Parity is the oldest and most intuitively appealing theory of exchange rate determination. Its core claim is deceptively simple: in the long run, exchange rates should adjust so that a given basket of goods costs the same in any two countries when measured in a common currency. If it costs INR 60,000 to buy a representative consumption basket in India, and USD 700 to buy the same basket in the US, the "correct" (PPP-implied) exchange rate is INR 60,000 / USD 700 = INR 85.71/USD. If the actual market rate is INR 83/USD, the rupee is "overvalued" relative to PPP — it buys more dollars (and therefore more US goods) than its domestic purchasing power would suggest.

3.1 The Law of One Price (LOOP)

The Law of One Price is the microeconomic foundation of PPP. It states that, in the absence of transportation costs, trade barriers, and other frictions, identical goods should sell for the same price in different markets when expressed in a common currency. If LOOP holds for Good X:

If LOOP is violated — if the Good X is cheaper in the US after converting at the market exchange rate — arbitrageurs will buy the good in the US, ship it to India, and sell it at the higher INR price, converting the INR proceeds back into USD at a profit. The arbitrage process increases demand for the good in the US (raising its USD price), increases supply in India (lowering its INR price), and generates demand for INR/USD conversion (moving the exchange rate). All three forces push toward LOOP restoration.

In practice, LOOP holds well for homogeneous commodities with low transportation costs — gold, crude oil, wheat, copper — where arbitrage is physically feasible. It holds poorly for differentiated goods (iPhones, automobiles, branded apparel), services that cannot be arbitraged (haircuts, restaurant meals, real estate), and goods subject to high trade barriers or taxes (alcohol, tobacco, electronics in high-tariff countries like India and Brazil).

3.2 Absolute Purchasing Power Parity

Absolute PPP extends the Law of One Price from a single good to a representative basket of all goods and services. It states:

Numerical Example 1 — Absolute PPP: Suppose a representative consumption basket costs INR 150,000 in India and USD 1,800 in the US. The absolute PPP-implied exchange rate is INR 150,000 / USD 1,800 = INR 83.33/USD. If the actual market exchange rate is INR 86/USD, the rupee is undervalued relative to PPP — it takes more rupees to buy the same goods in India than the PPP rate would suggest. Specifically: the INR is undervalued by (86 − 83.33) / 83.33 = 3.2%.

Absolute PPP in its pure form requires strong assumptions: (a) there are no transportation costs, tariffs, or other barriers to trade; (b) all goods are traded internationally; (c) the consumption baskets in the two countries are identical (same goods in the same proportions); and (d) there is no market power (prices equal marginal costs everywhere). These assumptions are never fully satisfied in reality, which is why absolute PPP rarely holds at any given point in time. However, the absolute PPP-implied rate provides a useful benchmark — a reference point against which to assess whether a currency appears overvalued or undervalued.

3.3 Relative Purchasing Power Parity

Relative PPP is the empirically more useful form of the theory. It does not claim that the level of the exchange rate equals the ratio of price levels — only that the change in the exchange rate over time should equal the difference in inflation rates between the two countries. Relative PPP is a theory of exchange rate dynamics, not of exchange rate levels.

The Logic: If India's inflation rate is 6% and the US inflation rate is 2%, Indian goods become 4% more expensive relative to US goods each year. To maintain purchasing power parity — to keep the real exchange rate constant — the rupee must depreciate by approximately 4% per year against the dollar. The rupee depreciation offsets the higher Indian inflation, keeping Indian goods competitively priced in global markets.

Numerical Example 2 — Relative PPP: The current spot rate is INR 83/USD. India's expected inflation rate is 6.5%. The US expected inflation rate is 2.5%. What is the expected spot rate one year from now under relative PPP?

Exact formula: e₁ = 83 × (1.065) / (1.025) = 83 × 1.03902 = INR 86.24/USD.

Approximation: %Δe ≈ 6.5% − 2.5% = 4.0%. e₁ ≈ 83 × 1.04 = INR 86.32/USD. (The approximation error is small — 8 paise, or 0.1% — and is acceptable for quick estimates.)

Interpretation: Relative PPP predicts that the rupee will depreciate from 83 to approximately 86.24 per USD over the next year, solely due to the inflation differential. This does not mean the rupee will definitely be 86.24 in one year — actual exchange rates are driven by many forces beyond relative inflation (interest rates, capital flows, speculation, intervention, shocks). Rather, 86.24 is the PPP-implied equilibrium rate — the rate that would keep the real exchange rate constant. If the actual rate diverges significantly from the PPP-implied rate, the currency is becoming overvalued or undervalued in real terms, which may signal future correction.

Numerical Example 3 — Forecasting the INR/USD Rate Over 5 Years: Spot rate = INR 83/USD. Expected annual inflation: India 6%, US 2.5%. What is the PPP-implied exchange rate in 5 years?

Using the exact formula over multiple periods: e₅ = 83 × (1.06)⁵ / (1.025)⁵ = 83 × 1.33823 / 1.13141 = 83 × 1.1828 = INR 98.17/USD.

This illustrates a critical feature of relative PPP: inflation differentials compound over time. A seemingly modest 3.5% annual inflation differential, compounded over 5 years, implies a cumulative depreciation of approximately 18.3%. Over 10 years, it would imply ~41% depreciation. Over 30 years (India post-1991), it implies an enormous cumulative depreciation.

4. The Big Mac Index and Empirical Evidence on PPP

4.1 The Economist's Big Mac Index

In 1986, The Economist magazine created the Big Mac Index — an accessible, informal test of PPP using the price of McDonald's Big Mac hamburger across countries. The Big Mac is a remarkably effective PPP proxy because it is a relatively standardised product (same ingredients, similar production process) produced locally in each country using local inputs, labour, and real estate — making its price sensitive to local cost conditions rather than just international arbitrage.

How to Read the Big Mac Index:

• Raw Index: Converts the local-currency price of a Big Mac into USD at the market exchange rate. If a Big Mac costs INR 220 in India and the market rate is INR 83/USD, the USD-equivalent price is USD 2.65. If a Big Mac costs USD 5.69 in the US, the Big Mac is cheaper in India — India's price is only 47% of the US price.
• Implied PPP Rate: INR 220 / USD 5.69 = INR 38.66/USD. This is the "burgernomics" exchange rate — the rate at which a Big Mac would cost the same in India and the US.
• Over/Undervaluation: (Actual Rate − Implied PPP Rate) / Implied PPP Rate. (83 − 38.66) / 38.66 = +114.7%. The Big Mac Index suggests the INR is 114.7% overvalued against the USD — a dramatic finding that illustrates both the power and the limitation of PPP as a simple, single-good indicator.

The Big Mac Index almost always finds that currencies of developing countries are undervalued against the USD relative to PPP — because non-traded inputs (labour, real estate, utilities) are cheaper in developing countries, making Big Macs (and most goods and services) cheaper there even after currency conversion. This is the Balassa-Samuelson effect in action: low productivity in developing-country non-tradable sectors keeps wages and prices low, producing a systematic PPP deviation that narrows (but does not fully close) as countries develop.

4.2 Empirical Evidence on PPP

The academic literature on PPP is vast and yields a nuanced set of findings:

1. PPP fails dramatically in the short run: Monthly and quarterly exchange rate changes bear essentially no relationship to contemporaneous inflation differentials. Exchange rates are far more volatile than relative prices — the standard deviation of monthly USD/DEM (now EUR/USD) exchange rate changes has historically been 8–10 times larger than the standard deviation of relative inflation rates. Capital flows, interest rate changes, and shifting expectations dominate price-level effects in the short run.
2. PPP performs better over long horizons: Over 5-year, 10-year, and 20-year horizons, the correlation between cumulative exchange rate changes and cumulative inflation differentials strengthens substantially. For high-inflation countries (where inflation is the dominant macroeconomic shock), PPP holds reasonably well even over 1–2 year horizons. For low-inflation developed countries (where other shocks — productivity, preferences, capital flows — are more important relative to inflation), PPP holds only over very long horizons (decades).
3. Mean reversion is slow: When exchange rates deviate from PPP, the deviation tends to narrow over time — but very slowly. Studies estimate a "half-life" of PPP deviations of 3–5 years for developed-country exchange rates. This means that if the rupee is 20% undervalued relative to PPP, it will take roughly 3–5 years for half of that undervaluation (10%) to be corrected — and potentially a decade or more for full correction. PPP is a long-run attractor, not a short-run predictor.
4. PPP holds better under fixed rates than floating rates: During the Bretton Woods era, when exchange rates were fixed, relative inflation rates were strongly correlated with future devaluations. Under floating rates, the relationship is much weaker — because nominal exchange rates can move for reasons unrelated to relative prices, and the two can decouple for extended periods.
5. PPP holds better for traded goods than for broad price indices: When PPP is tested using producer price indices (PPI, which heavily weight traded goods) rather than consumer price indices (CPI, which heavily weight non-traded services), the evidence is stronger. This confirms that the failure of short-run PPP is largely due to non-traded goods and services — the very items that LOOP cannot arbitrage.

5. Numerical Problems on Purchasing Power Parity

Solve the following problems. For each, show the formula, substitute the data, compute the result, and provide a one-sentence interpretation. Work in pairs for problems 1–4; problems 5–8 are for independent practice.

Problem Set — Guided Practice (Problems 1–4)

Problem 1 — Absolute PPP (Over/Undervaluation): A standardised consumption basket costs INR 200,000 in India and USD 2,500 in the United States. The current market exchange rate is INR 83/USD. (a) Calculate the absolute PPP-implied exchange rate. (b) Determine whether the rupee is overvalued or undervalued relative to PPP, and by what percentage.

Solution: (a) E_PPP = 200,000 / 2,500 = INR 80/USD. (b) (83 − 80) / 80 × 100 = +3.75%. The rupee is overvalued by 3.75% relative to PPP — the actual rate (83) is higher (weaker) than the PPP rate (80), meaning it takes more rupees to buy the same goods than PPP would predict.

Problem 2 — Relative PPP (Exact Formula): The current GBP/INR exchange rate is INR 105/GBP. The UK's expected inflation rate is 3.0%. India's expected inflation rate is 5.5%. Calculate the PPP-implied GBP/INR rate one year from now using the exact formula.

Solution: e₁ = 105 × (1.055) / (1.03) = 105 × 1.02427 = INR 107.55/GBP. The rupee is expected to depreciate against the pound by approximately 2.43% over the year, reflecting the 2.5 percentage point inflation differential.

Problem 3 — Relative PPP (Approximation vs. Exact): The current EUR/INR rate is INR 90/EUR. India's expected inflation = 6%. Eurozone expected inflation = 2%. (a) Calculate the PPP-implied rate one year from now using the approximation. (b) Calculate it using the exact formula. (c) Comment on the size of the approximation error.

Solution: (a) Approximation: %Δe ≈ 6% − 2% = 4%. e₁ ≈ 90 × 1.04 = INR 93.60/EUR. (b) Exact: e₁ = 90 × (1.06)/(1.02) = 90 × 1.03922 = INR 93.53/EUR. (c) The approximation error is INR 0.07 (0.07%) — negligible for practical forecasting purposes when inflation differentials are modest.

Problem 4 — Multi-Year Forecast: The current USD/INR rate is INR 83/USD. India's expected average annual inflation over the next 10 years is 5.5%. The US expected average annual inflation is 2.0%. Using relative PPP (exact formula), calculate the expected USD/INR rate in 10 years.

Solution: e₁₀ = 83 × (1.055)¹⁰ / (1.02)¹⁰ = 83 × (1.7081) / (1.2190) = 83 × 1.4013 = INR 116.31/USD. The rupee depreciates by approximately 40% over 10 years, solely due to the cumulative inflation differential.

Problem Set — Independent Practice (Problems 5–8)

Problem 5: An Indian financial manager observes that a particular machine tool costs INR 85,00,000 in India and USD 100,000 in the US. The current spot rate is INR 83/USD. Is it cheaper to buy the machine tool in India or the US? Calculate the PPP-implied rate and the percentage over/undervaluation.

Problem 6: The JPY/INR spot rate is INR 0.56/JPY (note: direct quote from India's perspective — INR per JPY). Japan's expected inflation is 1.5%. India's expected inflation is 6.0%. Using the exact relative PPP formula, calculate the expected JPY/INR rate in 2 years.

Problem 7: A Big Mac costs INR 230 in India and USD 5.80 in the US. The market exchange rate is INR 83/USD. (a) Calculate the Big Mac PPP-implied rate. (b) What is the percentage over/undervaluation of the rupee? (c) Explain why the Big Mac PPP-implied rate differs so dramatically from the actual rate — what does the Big Mac price capture that the broad CPI does not?

Problem 8 (Challenge): The INR/USD rate was INR 45/USD in 2010. Over the 14 years to 2024, India's cumulative inflation was approximately 130%, and US cumulative inflation was approximately 40%. Using relative PPP, what should the INR/USD rate be in 2024? The actual rate is INR 83/USD. Is the rupee overvalued or undervalued relative to PPP? Suggest two reasons why the actual rate might differ from the PPP-implied rate.

6. Scenario Debate: Exchange Rate Forecasting for Indian Firms

Four persona cards. Each group applies the demand/supply framework and PPP to forecast exchange rates and recommend financial strategies.

7. Fishbowl Debate: Can Exchange Rates Be Forecast?

8. Key Concepts & Terminology — Week 6

9. Session References & Further Reading

Required Reading

• Eun, C., Resnick, B., & Chuluun, T. — International Financial Management, McGraw Hill. Chapter 6: "International Parity Relationships and Forecasting Foreign Exchange Rates."
• Apte, P. G., & Kapshe, S. — International Financial Management, McGraw Hill. Chapter 5: "Exchange Rate Determination and Forecasting."

Classic Works

• Cassel, G. (1918). "Abnormal Deviations in International Exchanges." Economic Journal, 28(112), 413–415. (The original formulation of PPP by Gustav Cassel.)
• 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.
• Balassa, B. (1964). "The Purchasing Power Parity Doctrine: A Reappraisal." Journal of Political Economy, 72(6), 584–596.

Interactive Resources

• The Economist — Big Mac Index (interactive tool). Available at: https://www.economist.com/big-mac-index
• IMF — International Financial Statistics (exchange rates and inflation data for all member countries). Available at: https://data.imf.org
• RBI — Database on Indian Economy (INR exchange rates, NEER/REER indices, inflation). Available at: https://dbie.rbi.org.in