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INTERNATIONAL FINANCE

Module I

Syllabus

Balance of payments - Structure of BOP: Current Account; Capital Account; -

Disequilibrium - Adjustment mechanism - Relation between balance of payments and
foreign exchange rates- Theories of exchange rates - Purchasing Power Parity theory;
Interest rate Parity Theory; Arbitrage in forward market: Covered Interest Arbitrage;
International Fisher Effect – Factors influencing exchange rates. Numerical problems in
covered interest arbitrage to be covered.

Balance of Payments

Introduction

International trade and other international transactions result in a flow of funds between
countries. All transactions relating to the flow of goods, services and funds across
national boundaries are recorded in the balance of payments of the countries concerned.

What is Balance of Payments?

The Balance of Payments of a country is a systematic accounting record of all economic

transactions during a given period of times between the residents of the country and
residents of foreign countries- ie., the rest of the world.

Balance of payments is described by the IMF as a statistical statement for a given period
showing:

 Transactions in goods, services and income between an economy and the rest of
the world;

 Changes of ownership and other changes in the economy’s monetary gold, Special
Drawing rights (SDR), and claims and liabilities to the rest of the world; and

 Unrequited transfers (that is, a unilateral gift) and counter part entries that are
needed to balance.

Economic transactions include all those activities whereby two entities exchange
something of economic value; for example transactions involving goods, services,
income and financial claims.

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Thus, balance of payments presents a classified record of:

i. All receipts on account of goods exported, services rendered and capital received
by ‘residents’ and

ii. Payments made by them on account of goods imported and services received and
the capital transferred to ‘non-residents’ or ‘foreigners’.

The balance of payments includes both visible and invisible transactions. Balance of
payments for a country is the sum of the Current Account, the Capital Account, and the
change in Official Reserves.

Balance of Payments vs Balance of Trade

BOP is a classified statement of all receipts on account of goods exported, services

rendered, and capital received by residents, and payments made by them on account of
goods imported, services received from and capital transferred to non-residents or
foreigners.

Balance of trade refers to merchandise imports and exports (visible trade) by residents
with the rest of the world.

Thus, Balance of payments is a much wider term in its coverage as compared to balance
of trade. Whereas balance of trade refers to merchandise imports and exports (visible
trade), the BOP refers to all economic transactions – including ‘invisible transactions’
like banking, insurance, transport services, etc., with the rest of the world.

Accounting Principles

The BOP is a double entry accounting record. So every transaction has two aspects, a
debit aspect and a credit aspect. Since for every credit there is a corresponding debit, the
balance of payment must always balance.

Transactions are entered in the BOP account using the following rules:

Any transaction which results in an increase in demand for foreign exchange is to be

recorded as a debit entry while a transaction which results in an increase in the supply of
foreign exchange is to be recorded as a credit entry.

Another way of understanding the rule is through sources and uses of foreign currency.

Any transaction which is a source of foreign currency is a credit entry, and any
transaction which is a use is a debit entry.

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Thus an increase in foreign assets or reduction in foreign liabilities, because it is a use

foreign exchange, is a debit entry while a reduction in foreign assets or an increase in
foreign liabilities because it is a source of foreign exchange, is a credit entry.

Consider the following examples:

When a country exports goods to another country, it is a source of foreign exchange and
has to be credited in the BOP account. On the other hand, when a country imports goods,
it is a use of foreign exchange and has to be debited to the BOP account.

Thus the simple rule is that a transaction which increases the external purchasing power
of a country is recorded as a credit entry. It represents a source of foreign exchange.
Examples of such transactions are:

 Merchandise exports or export of goods;

 Export of services like travel, insurance, etc., or invisibles;

 A capital inflow into the country, i.e., borrowing abroad;

 Decrease in foreign exchange reserves and gold reserves of the monetary

authority.

A transaction which reduces the external purchasing power of the country is recorded as a
debit entry. It represents the use of foreign exchange reserves. Such transactions are:

 Merchandise imports and invisible imports;

 A capital outflow or lending abroad;

 Increase in foreign exchange reserves and gold reserves of the monetary authority.

Balance of Payments Credit and Debit

Credit Debit
1 . Exports of goods and services 1 . Imports of goods and services
2 . Income receivable from abroad 2. Income payable to abroad
3. Transfers from abroad 3. Transfers to abroad
4. Increase in external liabilities 4. Decrease in external liabilities
5. Decrease in external assets 5. Increase in external assets

Principles of Valuation of Transactions

Every year, a large number of transactions enter the BOP account of each country. To
make the data comparable across countries and over a period of time, it is essential that a

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uniform system be adopted for valuing these transactions. The IMF manual
recommends the following principles to be followed for valuation of transactions
entering the BOP account:

The transactions should be valued at market prices. For this purpose, the manual
describes market price as "the amount of money that a willing buyer pays to acquire
something from a willing seller”.

Both imports and exports should be valued at f.o.b. basis (i.e. free on board basis).
This means that the price paid for the insurance and shipment of goods should not be
included as a part of the value of goods either by the importer or the exporter, but
should be recorded separately as a payment for services (wherever paid to a foreign
agency).

Any transaction denominated in a foreign currency should be converted into the

domestic currency at the exchange rates prevailing in the market at the time the
transaction took place.

Principles of Timing the recording of Transactions

Every transaction is recorded by the two countries involved. To avoid discrepancies, it is

necessary that both the countries record it in the same period in their BOP accounts.
Also, the two sides of transaction should be recorded in the same time period to make
the BOP statement balance. For the above mentioned reasons, the IMF manual
prescribes some rules as to when a transaction should be recorded in the BOP account.
The rules are as follows:

Current Account: Merchandise trade should be recorded when the change in ownership
takes place. This is said to happen when the corresponding payment is made. Trade in
services is to be recorded when the services are actually rendered. Interest, dividends
and other like payments are to be recorded when they are due for payment. The rule
for transfer payments is that they should be recorded when the ownership of the
underlying assets changes.

Capital Account: Capital account transactions are also recorded when the change in
ownership takes place. For these transactions, the change in ownership is assumed to
have taken place when the transaction goes through the banking channels. International
loan drawings are recorded at the time of the actual disbursement of the loan and not
when the lender commits to lend or sanctions the loan.

Components of Balance of Payments

The BOP is a collection of accounts conventionally grouped into three main categories:

The Current Account: Under this are included imports and exports of goods and
services and unilateral transfers of goods and services.

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The Capital Account: under this are grouped transactions leading to changes in foreign
financial assets and liabilities of the country.

The Official Reserve Account: It measures the changes in holdings of gold and
foreign currencies (reserve assets) by official monetary institutions. Reserve assets are
assets which the monetary authority of the country uses to settle the deficits and surpluses
that arise on the other two categories take together.

The Current Account

The Current Account records the transactions in merchandise and invisibles with the rest
of the world. In other words, current account records all flows of goods, services, and
transfers. The structure of current account is given below:

Credit Debit Net

A. CURRENT ACCOUNT

1. MERCHANDISE
a. Exports (on f.o.b. basis)
b. Imports (on c.i.f. basis)
2. INVISIBLES (a + b + c)
a. Services
i. Travel
ii. Transportation
iii. Insurance
iv. Government not elsewhere Classified
v. Miscellaneous
b. Transfers
vi. Official
vii. Private
c. Income
i. Investment income
ii. Compensation to employees
Total Current Account (1 + 2)

Merchandise: Merchandise covers exports and imports of all movable goods, where the
ownership of goods changes from residents to non-residents and vice versa. Exports are
valued on f.o.b. (free on board) basis and are shown as credit items. Imports are valued
on c.i.f. (cost, insurance and freight) basis and are shown as debit items. The difference
between the total of credits and debits appears in the net column.

Invisibles: Conventionally, trade in physical goods is distinguished from trade in

services. The item invisibles include services such as travel, transportation, insurance,
investment income, and other miscellaneous items. The credits under invisibles consist of

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the value of services rendered by residents to non-residents. The income earned by

residents from ownership of foreign financial assets (interests, dividends), income earned
from the use, by non-residents, of non-financial assets such as patents and copyrights
owned by residents are all recorded as credits. Similar remittances made by residents to
non-residents are recorded as debits.

A credit entry of the like Governments not elsewhere classified includes items like
funds received from a foreign government for the maintenance of their embassy,
consulates, etc in India.

Under the heading ‘Miscellaneous’, payments to a foreign technical consultant for

professional services rendered will appear as debit item.

Transfers may be of two types: official and private. A debit entry under the heading
Official transfers constitute items like revenue contributions by the Government of India
to international institutions or any transfer (even in the form of gifts) of commodities by
the government to non-residents. Private transfers include items like cash remittances by
the non-residents Indians for their family maintenance in India.

The Capital Account

The structure of Capital Account in BOP statement is shown below:

Credit Debit Net

B. CAPITAL ACCOUNT
1. FOREIGN INVESTMENT (a + b)
a. In India
i. Direct
ii. Portfolio
b. Abroad
2. LOANS (a + b +c)
a. External Assistance
i. By India
ii. To India
b. Commercial Borrowings (MT and LT)
i. By India
ii. To India
c. Short-term
To India
3. BANKING CAPITAL (a + b)
a. Commercial Banks
i. Assets
ii. Liabilities
iii. Anon-Resident Deposits

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b. Others
4. RUPEE DEBT SERVICE
5. OTHER CAPITAL
Total Capital Account (1 + 2 + 3 + 4 +5)

In the case of the Capital Account an increase (decrease) in the country's foreign
financial assets are debits (credits) whereas any increase (decrease) in the country's
foreign financial liabilities are credits (debits).

All transactions of financial nature are entered in the Capital Account of the BoP
statement. The transactions under this heading are classified into five heads: (1)
Foreign Investment, (2) Loans, (3) Banking Capital, (4) Rupee Debt Service and (5)
Other Capital.

Any investment made by foreign residents (individuals, companies, financial institutions

or even a foreign government) in the acquisition of physical assets in India is a Foreign
Direct Investment. It is depicted by an inflow of foreign capital and is a credit item in
the BoP Statement. When a foreign country portfolio investor directly purchases financial
assets in the Indian securities market it is termed as Foreign Portfolio Investment.

Loans include concessional loans received by the government or public sector

bodies, long-term and medium-term borrowings from the commercial capital market
in the form of loans, bond issues, etc., and short-term credits. Disbursements
received by Indian resident entities are credit items while repayments and loans made
by Indians are debit items.

Banking capital covers the changes in the foreign assets and liabilities of
commercial banks whether privately owned or government owned and co operative
banks which are authorized to deal in foreign exchange. An increase in assets (or
decrease in liabilities) is a debit item while a decrease in assets (or increase in
liabilities) is a credit item.

The item `Rupee Debt Service' is defined as the cost of meeting interest payments and
regular contractual repayments of principal of a loan along with any administration
charges in rupees by India.

The remaining accounts in BOP are set out below:

Credit Debit Net

C. ERRORS AND OMISSIONS

D. OVERALL BALANCE (A + B + C)
E. MONETARY MOVEMENTS (i + ii)
i. Foreign Exchange Reserves (increase-/Decrease+)

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Errors and Omissions

Though recording of transactions in the BoP statement is made according to the

principle of double entry, certain discrepancies in estimation and timing may result in a
situation where debits are not exactly equal to the credits. The item `Errors and
Omissions' indicates the value of such discrepancies. A negative value indicates that
receipts are overstated or payments are understated, or both, and vice versa. Persistently,
large errors with the same sign are indicative of serious weaknesses in the recording
of transactions or flows.

Monetary Movements

The monetary movements keep record of (a) India's transactions with the International
Monetary Fund (IMF), and, (b) India's foreign exchange reserves which basically
consist of RBI holdings of gold and foreign currency assets. Drawings (essentially a
type of borrowing) from the IMF or drawing down of reserves are credit items,
whereas, repayments made to IMF or additions made to existing reserves are debit
items.

Deficit and Surplus in the Balance of Payments

By definition, the BoP account always balances. Yet, the individual components may or
may not balance. This in reality gives rise to the widely discussed deficits or surplus
arising in the BoP account. A net inflow on account of merchandise trade results in
a trade surplus, while a net outflow results in a trade deficit. In the same way, a net
inflow after taking all entries in the current account into consideration is referred to
as the current account surplus, and a net outflow as current account deficit.
The capital account records movements on account of international purchase or sale
of assets. Assets include any form in which wealth may be held - money held as cash or
in the form of bank deposits, shares, debentures, other debt instruments, real estate,
land, factories, antiques, etc. Any purchase of a foreign asset by a resident is entered
as a debit item in that country's BoP account, while any purchase by a foreign resident
of a domestic asset is recorded as a credit item. The excess of the credits over debits in
the capital account over a particular period is referred to as the capital account surplus.
The excess of debits over credits is known as capital account deficit.

When Current Account + Capital Account show a surplus, it is defined as overall BoP
surplus and if the sum is a deficit, it is overall BoP deficit. Overall BoP surplus results in
an increase in the forex reserves and of the country and a deficit to a decline in the forex
reserves.

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Relation between Balance of Payments and Foreign Exchange Rates

All credit entries in the BOP give rise to the demand for home currency and to supply of
foreign currency, whereas all debit entries give rise to the supply of home currency and
to the demand for foreign currency. When goods and services are sold to overseas
buyers, the overseas buyers (importers) may have to purchase the home currency of the
exporter in order to make payment for the goods and services exported. Even if the
exports of goods and services are invoiced in the foreign currency, the exporter will
purchase the home currency by selling the foreign currency which he receives. In either
case, the exports give rise to a demand for home currency in the foreign exchange
market. Conversely, the importing of goods and services gives rise to a supply of home
currency. Because, the importer will have to supply the home currency in order to make
payment to the exporter. If the goods and services are invoiced in the foreign currency,
the importer has to buy the foreign currency by supplying the adequate home currency.
Similarly, unilateral transfers like receipt of gifts, grants, aid, etc would also give rise to
a demand for the home currency as in the case of export of goods and services, and
unilateral transfers to foreigners would give rise to a supply of the home currency in the
same way as the imports. It is to be noted that the demand for home currency results in
the supply of foreign currency as the supply of home currency is associated with the
demand for foreign currency.

Thus the economic transactions between nationals give rise to a supply of and demand
for a country’s currency which in turn would determine the foreign exchange rate. As
the economic transactions between a country and other nations depend on income and
price changes in the country, the disequilibrium (deficit or surplus) in the balance of
payments of a country can be adjusted through monetary and fiscal policies.

BOP under Flexible Exchange Rate Regime

Under the flexible exchange rate regime, the exchange rates are determined by the forces
of demand for and supply of currencies. With flexible exchange rates, there is no change
in the official reserve position, and accordingly the deficit or surplus in the current
account will be exactly equal to the surplus or deficit in the capital account. Thus,
Current Account Balance ≡ ( - ) Capital Account Balance
Current Account Balance + Capital Account Balance = 0

The direction of causation may be from either side. For instance, a country’s current
account deficit may be the result of too much foreign borrowing. Alternatively, a deficit
in the current account due to increase in imports, makes a country to have to raise funds
from abroad by issuing securities or divest itself of its foreign assets.

As the exchange rates are determined by the forces of supply and demand for foreign
exchange, the exchange rate of a currency varies with the varying supply and demand
situations. Any disequilibrium (a deficit or a surplus) in a country’s balance of payments
can be corrected through changes in the exchange rates. If a country is in deficit in its
balance of payments, the exchange rate of its currency would depreciate as a

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consequence. This makes the country’s exports cheaper in terms of foreign currency,
and at the same time it makes the country’s imports dearer in terms of its domestic
currency. As a result, the exports of the country would get encouraged and the imports
would get discouraged. This will ultimately adjust the deficit in the country’s BOP.
Conversely, if a country is in a surplus in its BOP, the exchange rate would appreciate as
a consequence. This makes the country’s exports dearer in terms of a foreign currency
and at the same time it also makes the country’s imports cheaper in terms of the
domestic currency. As a result, exports get discouraged and imports get encouraged.
Adjustment of a surplus in the BOP is brought about in this way. The flexible exchange
rate system thus automatically keeps the BOP of all countries in equilibrium. It has also
been observed that the flexible exchange rate system would solve the problem of
international liquidity by keeping the BOP of all countries in equilibrium.

The J-Curve Effect

The phenomenon of deterioration and eventual improvement in a country’s balance of
trade is known as the J-curve effect.

Depreciation in a country’s currency would increase the prices of imports in terms of

domestic currency. The increase in prices of imports may reduce the quantity of
imports. However, if price elasticity of demand is inelastic for imported goods, the
higher prices of imports may result in higher value of imports. In other words,
depreciation in the home currency may deteriorate the country’s balance of trade. But
depreciation in domestic currency makes exports cheaper in terms of foreign currency
and this will increase the volume of exports. The value of exports thus increases with
the quantity of exports. However, if the export demand is price inelastic, then
depreciation in the home currency may not cause increase in the volume of exports.
Further, in the short run, exports may not increase even with the decline in export prices.
This is because exporters may need more time to produce more to meet the increasing
demand. It would also be some time before the foreign customers switch to imported
products though they are cheaper. In other words, a country’s balance of trade may
deteriorate following depreciation of its currency when the value of exports does not
sufficiently increase to compensate for the increase in the value of imports.

The worsening of a country’s balance of trade following depreciation of its currency is

temporary. In the long-run, many import substitutes would be brought into the market
and the resident customers would also adjust their preferences towards import
substitutes. Similarly, in the long run, exporters would be able to increase their
production and the foreign customers would also switch over to these products. As a
result, the country’s balance of trade would turn around and eventually improve. The
phenomenon of deterioration and eventual improvement in a country’s balance of trade
is known as the J-curve effect.

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J-curve after depreciation of currency

Appreciation of the exchange rate may bring contra picture of the J-curve. Following an
appreciation of a country’s currency, the exports would become dearer and imports
would become cheaper. But due to inelasticity of exports and imports, the quantity of
imports and exports may not change in the short run. Following the appreciation of the
home currency and consequent reduction in the prices of imported products in terms of
home currency, the total spending on imports may come down if the quantity imported
does not increase due to price inelasticity of demand. However, the value of exports
may decline in the short turn following appreciation of the country’s currency. If the
exports do not decline as much as the decline in the value of the imports, the country’s
balance of trade would really show a surplus in the short run. However, in the long run,
the quantity of imports would increase following a decline in import prices, and the
quantity of exports would also decrease following an increase in the foreign currency
prices of exports. The net result is a worsening of the country’s balance of trade
following an appreciation of its currency. If this phenomenon is plotted on a graph, it
would take the shape of the inverted J-curve.

J-curve after appreciation of currency

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Thus, depreciation or appreciation of a country’s currency against a foreign currency

would make the exchange rate unstable in the short-run due to inelastic imports and
inelastic exports. However, the other factors which also have a bearing on the exchange
rate may become dominant and bring stability in the exchange rates, depreciation or
appreciation of the country’s currency notwithstanding.

BOP under Fixed Exchange Rate Regime

Under the fixed exchange rate system, the disequilibrium in BOP can be corrected by
effecting suitable changes in the official reserves. The government may buy the excess
amounts of its currency to prevent the exchange rate from falling and may supply
whatever excess amounts of its currency are demanded in order to prevent the exchange
rate from increasing. The buying or selling of domestic currency is done through the
official reserve account of the country’s BOP.

Furthermore, the country may initiate certain other measures to correct disequilibrium in
its BOP. These measures are directly aimed at encouraging exports and discouraging
imports. Export promotion measures include devaluation of domestic currency, control
of inflation, and improving the production facilities in the country so as to augment
production. Imports can be discouraged by increasing tariffs, fixing import quotas,
revaluation of domestic currency, and encouraging the use of import substitutes.

EQUILIBRIUM, DISEQUILIBRIUM AND ADJUSTMENT

Accounting and Economic Equilibrium

Since the balance of payments is constructed on the basis of double-entry book keeping,
credit is always equal to debit. If debit on current account is greater than the credit side,
funds flow into the country that is recorded on the credit side of the capital account. The
excess of debit is wiped out. It means that the balance of payments is always in
accounting equilibrium.

The accounting balance is an ex post concept. It describes what has actually happened
over a specific past period. There may be accounting disequilibrium for a short period
when the two sides of the autonomous flows differ in size. But in such cases,
accommodating flows bring the balance of payments back to equilibrium. To make the
distinction between the autonomous flow and accommodating flow more clear, it can be
said that foreign investment, external assistance and commercial borrowings are
autonomous capital flow because they flows in normal course of business. But when the
country borrows from the International Monetary Fund to meet the overall deficit, such
borrowings represent accommodating capital flow.

However, in real life, economic equilibrium is not found because the two sides of the
current account are seldom equal. Rather it is the economic disequilibrium in the balance
of payments that is a normal phenomenon.

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Process of Adjustment

The focus of adjustment lies primary on the trade account, although the size of adjusting
deficit is sometimes reduced by the net inflow on the invisibles account. There are
different views on adjustment that need a brief discussion here.

The Classical Approach

The classical economists were of the view that the balance of payments was self adjusting
due to the price-specie-flow mechanism. The mechanism stated that an increase in money
supply raises domestic prices. Exports become uncompetitive. Export earnings drop.
Foreign goods become cheaper. Imports rise. Current account balance goes deficit in the
sequel. Precious metal flows outside the country in order to finance imports. As a result,
quantity of money lessens that lowers the price level. Lower prices in the economy lead
to greater export. Trade balance reaches back to equilibrium.

Elasticity Approach

The adjustment in the balance of payments disequilibrium is thought of in terms of

changes in the fixed exchange rate, that is through devaluation or upward revaluation.
But its success is dependent upon the elasticity of demand for export and import.
Marshall (1924) and Lerner (1944) explained this phenomenon through the "elasticity"
approach.

The elasticity approach is based on partial equilibrium analysis where everything is held
constant except for the effects of exchange rate changes on export or import. It is also
assumed that elasticity of supply of output is infinite so that the price of export in home
currency does not rise as demand increases, nor the price of import falls with a squeeze in
demand for imports. Again, the approach ignores the monetary effects of variation in
exchange rates. 44 Environment International Financial

If the elasticity of demand is greater than unity, the import bill will contract and export
earnings will increase as a sequel to devaluation. Trade deficit will be removed. However,
the problem is that the trade partner may also devalue its own currency as a retaliatory
measure. Moreover, there may be a long lapse of time before the quantities adjust
sufficiently to changes in price. Till then, trade balance will be even worse than that
before devaluation.

Stem (1973) incorporated the concept of supply elasticity in the elasticity approach.
Based on the figures of British exports and imports, Stem has come to a conclusion that
the balance of trade should improve if:

1. Elasticity of demand for exports and imports is high and is equal to one coupled with
elasticity of supply both for imports and exports which is either high or low.

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2. Elasticity of demand for imports and exports is low but the elasticity of supply for
imports and exports is lower.

On the contrary, if the elasticity of demand is low matched with high elasticity of supply,
the balance of trade should worsen.

The Keynesian Approach

The Keynesian view takes into consideration primarily the income effect that was ignored
under the elasticity approach. There are various versions of the Keynesian approach. One
is the absorption approach that explains the relationship between domestic output and
trade balance and conceives of adjustment. Sidney A. Alexander (1959) treats balance of
trade as a residual given by the difference between what the economy produces and what
it takes for domestic use or what it absorbs. He begins with the contention that the total
output, Y is equal to the sum of consumption, C, investment, I, government spending, G,
and net export (X-M). In form of an equation,

Y=C+I+G+(X-M)

Substituting C +l+ G by absorption, A, it can be rewritten as:

Y=A +X-M

or Y-A=X-M

This means that the amount, by which total output exceeds total spending or absorption is
represented by export over import or the net export which means a surplus balance of

trade. This also means that if A > Y, deficit balance of trade will occur. This is because
excess absorption in absence of desired output will cause imports. Thus in order to bring
equilibrium in the balance of trade, the government has to increase output or income.
Increase in income without corresponding and equal increase in absorption will lead to
improvement in balance of trade.

In case of full employment, where resources are fully employed, output cannot be
expanded. Balance of trade deficit can be remedied through decreasing absorption
without equal fall in output. It may be noted that validity of absorption approach depends
upon the operation of the multiplier effect that is essential for accelerating output
generation, It also depends on the marginal propensity to absorb that determines the rate
of absorption.

J. Black (1959) explains the absorption in a slightly different way. He ignores the
governmental expenditure, G and equates X - M with S - I (where S is saving and I is
investment). He is of the opinion that when balance of trade is negative, the country has
to increase saving on the one hand and to reduce investment, on the other. In case of full

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employment, he suggests for redistribution of national income in favour of profit earners

who possess greater propensity to save. 45 Flows International Financial

Again, Mundell (1968) incorporates also interest rate and capital account in the ambit of
discussion. In his view, it is not only the government spending but also the interest rate
that does have an influence on income as well on the balance of payments. While larger
government spending increases income, an increase in income leads to rise in import.
With a positive marginal propensity to import, any rise in income as a sequel to increase
in government spending will lead to greater imports and worsen the current account.
However, changes in interest rate influence both the capital account and the current
account. A higher interest rate will lead to improvement in current account through
lowering of income. At the same time, a higher interest rate will improve the capital
account through attracting the flow of foreign investment.

Yet again, the New Cambridge School approach takes into account savings (S) and
investment (I), taxes (T) and government spending (G) and their impact on the trade
account. In form of equation, it can be written as:

S+T+M=G+X+I

Or ( S - I ) + (T-G) + ( M-X) = 0

Or (X-M) = ( S - I ) + (T- G)

The theory assumes that (S - I) and (T - G) are determined independently of each other
and of the trade gap. (S - I) is normally fixed as the private sector has a fixed net level of
saving. And so the balance of payments deficit or surplus is dependent upon (T - G) and
the constant (S - I). In other words, with constant (S - I), it is only the manipulation of (T
- G) which is a necessary and sufficient tool for balance of payments adjustment.

Monetary Approach

The monetarists believe that the balance of payments disequilibrium is a monetary

phenomenon and not structural (Connolly, 1978). The adjustment is automatic unless the
government is intentionally following an inflationary policy for quite a long period.
Adjustment is brought about through making changes in monetary variables.

The process of adjustment varies among the types of exchange rate regime the country
has opted for. In a fixed exchange rate regime or in gold standard, if the demand

for money, that is the amount of money people wish to hold is greater than the supply of
money, the excess demand would be met through the inflow of money from abroad. On
the contrary, with the supply of money being in excess of the demand for it, the excess
supply is eliminated through the outflow of money to other countries. The inflow and the

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outflow influence the balance of payments. To explain it further, with constant prices and
income and thus constant demand for money, any increase in domestic credit will lead to
outflow of foreign exchange as the people will import more to lower the excessive cash
balances. In the sequel, the balance of payments will turn deficit. Conversely a decrease
in domestic credit would lead to an excess demand for money. International reserves will
flow in to meet the excess demand. Balance of payments will improve.

However, in a floating-rate regime, the demand for money is adjusted to the supply of
money via changes in exchange rate. Especially in a situation when the central bank
makes no market intervention, the international reserves component of the monetary 46
Environment International Financial

base remains unchanged. The balance of payments remains in equilibrium with neither
surplus nor deficit. The spot exchange rate is determined by the quantity of money
supplied and the quantity of money demanded.

When the central bank increases domestic credit through open market operations, supply
of money is greater than the demand for it. The households increase their imports. With
increased demand for imports, the domestic currency will depreciate and it will continue
depreciating until supply of money equals the demand for money. Conversely, with
decrease in domestic credit, the households reduce their import. Domestic currency will
appreciate and it will continue appreciating until supply of money equals demand for
money.

In case of managed floating, the central bank often intervenes to peg the rates at some
desired level. And so this case is a mix of fixed and floating rate regimes. It means that
changes in the monetary supply and demand do influence the exchange rate but also the
quantum of international reserves.

Exchange Rate Determination

Foreign Exchange rates are affected by a number of factors. There are certain theories
which try to explain the movement of exchange rates and the influence of certain factors
on the exchange rate. For example, two important factors which influence exchange rates
are inflation and interest rates. The relationship between inflation and exchange rate is
explained by the Purchasing Power Parity Principle and the relationship between interest
rate and exchange rate is explained by Interest Rate Parity Principle.

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Theories of Exchange Rate (Theories of Exchange Rate Determination)

The following are the major theories of exchange rate:

 The Mint Parity Theory

 The Balance of Payments Theory
 The Purchasing Power Parity Theory (PPP)
 The Interest Rate Parity Theory (IRP) and
 The International Fisher Effect Theory

Mint Parity Theory

When the currencies of two countries are on a metallic standard (gold or silver), the rate
of exchange between them is determined on the basis of parity of mint ratios between the
currencies of the two countries. The theory explaining the determination of exchange rate
between countries which are on the same metallic standard (say, gold coin standard) is
known as the Mint Parity Theory of foreign exchange rate.
By mint parity is meant that the exchange rate is determined on a weight-to-weight basis
of the two currencies, allowance being made for the parity of the metallic content of the
two currencies. Thus, the value of each coin (gold or silver) will depend upon the amount
of metal (gold or silver) contained in the coin and it will freely circulate between the
countries.
Under the system of gold standards, for instance, the rate of foreign exchange is
determined in terms of the gold content of the two given currency units. This is referred
to as mint parity. Thus, if currency A contains 10 grams of gold and В contains 5 grams
of gold, then rate of exchange is: 1A = 2B.
Today, however, the method of determining currency value in terms of gold content or
mint parity is obsolete for the obvious reasons that: (i) none of the modern countries in
the world is on gold or metallic standard, (ii) free buying and selling of gold
internationally is not permitted, by various governments and as such it is not possible to
fix par value in terms of gold content or mint parity, and (iii) most of the countries today
are on paper standard or Fiat currency system.

Balance of Payments Theory

The Balance of Payments Theory states that the exchange rate of the currency of a
country depends upon its Balance of Payments. According to this theory, an adverse
balance of payment, lead to the depreciation of the foreign exchange rate while a
favourable balance of payments causes an appreciation of the foreign exchange rate.

When the balance of payments is adverse, it indicates a situation in which a demand for
foreign exchange exceeds its supply at a given rate of exchange. Consequently, the price
of the foreign currency in terms of domestic currency must rise and the value of the

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domestic currency must depreciate. Conversely, if the balance of payment is favourable it

means that there is a greater demand for domestic currency in the foreign exchange
market. Consequently, the price of domestic currency in terms of foreign currency rises
i.e., the rate of exchange moves in favour of home currency.

Balance of Payment theory is also known as the Demand and Supply theory.

The general equilibrium theory of exchange rate holds that the foreign exchange rate,
under free market conditions is determined by the conditions of demand and supply in the
foreign exchange market. When the Balance of Payment is equilibrium, the demand and
supply for the currency are equal. But when there is a deficit in the balance of payments,
supply of the home currency exceeds its demand and causes a fall in the external value of
the home currency. When there is a surplus in the balance of payments, demand of home
currency exceeds its supply and causes a rise in the external value of the home currency.

Purchasing Power Parity Principle (PPP)

The Purchasing Power Parity (PPP) Principle examines the relationship between inflation
and the exchange rates.

According to the Purchasing Power Parity Principle, the price levels and inflation in
different countries determine the exchange rates of those countries’ currencies. PPP is
based on the Law of One Price.

The Law of one Price

According to the law of one price, in the absence of frictions to international trade such
as shipping costs and tariffs, the price of identical goods, when expressed into a common
currency at the spot exchange rate, have to be the same in different countries,. If it were
not true, arbitrageurs would drive the price towards equality by buying in the cheaper
market and selling in the expensive market.

For example, if the cost of steel in United States (in Rupee terms) is Rs. 35,000 per tonne
and in India it is Rs. 30,000 per tonne, arbitrageurs would start buying steel in India to
sell it in U.S. This would increase the steel prices in India and reduce the prices in U.S.
This process will continue till steel becomes equally priced in both the countries.

We have seen that the price of any commodity has to be the same in different countries
when they are expressed in the same currency everywhere (Rupee price in our example).
What about when prices are expressed in different foreign currencies? This is where the
law of one price links exchange rates to commodity prices.

According to the law of one price, in the absence of frictions such as shipping costs and
tariffs, the price of a commodity when converted into a common currency such as Indian
Rupee, using the prevailing spot exchange rate has to be the same in every country.

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For example, if the price of a commodity in India is PIN and the price of the same
commodity in United States is PUS and if the spot exchange rate between Indian Rupee
and U.S. Dollar is S(Rs/$), then according to the law of one price,

PIN = S(Rs/$) x PUS

Purchasing Power Parity Principle (PPP)

When the above law of one price is applied internationally to a standard basket of
commodity, we obtain the theory of purchasing power parity.

According to the law of one price, in international context, if the price of a standard
basket of commodity in India is PIN and the price of the same standard basket of
commodity in United States is PUS and if the spot exchange rate between Indian Rupee
and U.S. Dollar is S(Rs/$), then

PIN = S(Rs/$) x PUS

By rearranging the above equation we get,

S(Rs/$) = PIN / PUS

The above relationship is known as Purchasing Power Parity Principle.

Thus, the Purchasing Power Parity Principle (PPP) states that the exchange rate between
currencies of two countries should be equal to the ratio of these countries’ price levels.

For example, if the price of a standard commodity basket in India is Rs. 2,700 and the
price of the same basket of commodity in U.S. is $ 50 then according to PPP, the spot
exchange rate between Indian Rupee and U.S. Dollar would be

S(Rs/$) = Rs.2,700/$50 = Rs54/$

The Purchasing Power Parity Principle is based on the following assumptions:

 There is no restriction on the movement goods between countries. That is, there is
no restriction on international trade, either in the form of a ban on exports or
imports, or in the form of quotas.
 There is no transportation cost.
 There is no transaction cost involved in the buying and selling of goods.
 There are no tariffs.
 There is no transaction cost in foreign exchange market.
 The same basket of commodities is consumed in different countries.

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There are two different forms of PPP– the absolute form of PPP and the relative form of
PPP.

The Absolute Form of PPP

The absolute form of PPP states that the exchange rate between two countries’ currencies
is determined by the respective price levels in the two countries. In fact, according to the
absolute form of PPP, the exchange rate between currencies of two countries should be
equal to the ratio of the countries’ price levels. The absolute form of PPP is represented
by the following equation

S(A/B) = PA/PB
Where,

S(A/B) is the spot exchange rate between currencies of country A and country B
and PA and PB are the prices of the same basket of goods in countries A and B. The
absolute form of PPP gives the relationship between spot exchange rate and price levels
at a particular point of time.

The Relative Form of PPP

We have seen that the absolute form of PPP gives the relationship between the spot
exchange rate and price levels at a particular point of time. On the other hand, the relative
form of PPP gives the relationship between the changes in spot rates and changes in price
levels over a period of time. According to this theory, changes in spot rate over a period
of time reflect the changes in the price levels over the same period in the concerned
economies. In other words, the relative form of purchasing power parity states that the
rate of change of the exchange rate equals the difference between the inflation rates in the
two countries.

The relative form of PPP can be derived from the absolute form of PPP in the following
manner:

Let S*(A/B) denote the percentage change in the spot exchange rate between currencies
of Countries A and B over a year, and P*A and P*B denote the percentage change in the
price levels, i.e., the inflation rates in the two countries over the same period of time.
According to absolute form of PPP,

PA = S(A/B) x PB (1)

Then at the end of one year,

PA (1+P*A) = S(A/B){1+S*(A/B)} x PB x (1+P*B) (2)

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The left-hand side of the equation gives the price level in country A after one year, the
first term of the right-hand side of the equation gives the spot exchange rate between the
two currencies at the end of one year, and the last term gives the price level in country B
after one year.

Dividing equation 2 by equation 1 we get,

(1+P*A) = {1+S*(A/B)} x (1+P*B)

Rearranging the above equation, we get,

1+P*A
*
1+S (A/B) =
1+P*B

1+P*A
*
S (A/B) = -1
1+P*B

P*A – P*B
*
S (A/B) = (3)
*
1+PB

The above equation (7) represents the relative form of Purchasing Power Parity Principle.

If the inflation rate in country B is small, the above equation can be approximated as,

S*(A/B) = P*A – P*B

Thus, the relative form of PPP states that the change in the exchange rate between
currencies of two countries should be equal to the inflation rate differential between those
countries.

The relative form of PPP can also be stated in the following form:

F(A/B) 1 + P*A
=
S(A/B) 1 + P*B

Where, F(A/B) and S(A/B) are the forward and spot exchange rates between currencies
of countries A and B and P*A and P*B are inflation in countries A and B.

The relative form of PPP relaxes a number of assumptions made by the Law of One Price
and the absolute PPP. These are:

 Absence of transaction costs

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 Absence of transportation costs

 Absence of tariffs.

Empirical Evidence regarding PPP

A multitude of studies have been conducted over a number of years to verify whether the
law of one price and the various forms PPP actually hold good. The existing empirical
evidence, however, indicates that PPP does not hold good, i.e., the movement in exchange
rates are not explained by movements in price levels. A major reason for this happening is
that there are a number of other factors which also affect the movements in exchange
rates, especially in the short term, which may dominate the effect of inflation.

Reasons for PPP not holding good

As PPP is the manifestation of the law of one price applied to a standard commodity
basket, it will hold good only if the prices of constituent commodities are equalized
across countries in a given currency and if the composition of the consumption basket is
the same across countries. If any of the assumptions of the law of one price does not hold
good, the PPP would also not hold good. The following are the reasons for PPP not
holding good

a) Constraints on movement of commodities: One of the constraints on movement

of goods between two countries is transportation cost. Another constraint is the
presence of tariffs. These factors allow deviations in prices, and hence, a
deviation from absolute PPP. Another factor which affects both absolute as well
as relative PPP, is the presence of quota imposed on exports and imports to a
country.
b) Price index construction: Movements in prices are generally measured by price
indexes. Price indexes used in different countries are based on different baskets
of commodities. When these indexes are used to measure the movement in price
levels, the results do not conform to PPP.

Interest Rate Parity (IRP)

The PPP gives the equilibrium condition in the commodity market. Its equivalent in the
financial markets is a theory called the Interest Rate Parity (IRP) or the covered interest
parity condition.

According to this theory, the cost of money (i.e the cost of borrowing money or the rate
of return on financial investments), when adjusted for the cost of covering foreign
exchange risk, is equal across different currencies. This is so, because in the absence of
any transaction costs, taxes and capital controls (i.e. restriction on international
investments and financing), investors and borrowers will tend to transact in those
currencies which provide them the most attractive prices. Besides, the arbitrageurs will
always be on the lookout for an opportunity to make riskless profits. The resultant effects
on the demand and supply would drive the value of currencies towards equalization.

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Statement of Interest rate Parity Theorem

The cost of money (i.e the cost of borrowing money or the rate of return on financial
investments), when adjusted for the cost of covering foreign exchange risk, is equal
across different currencies.

Let us examine the IRP from the point of view of an investor.

Suppose a corporate has surplus funds for a period of one year. It could either invest them
in securities denominated in the domestic currency, or in securities denominated in any
other foreign currency. The returns it will earn if it invests in securities denominated in a
foreign currency will depend on two factors – the interest rate on those securities, and the
exchange rate movement. With exchange rates being flexible, there is always the risk of
exchange rates moving unfavourably. Since an investment in securities denominated in
the domestic currency does not face any exchange risk, the same risk will have to be
removed from other investments as well, in order make their return comparable. The
investor can do this by entering into a forward contract for the relevant maturity. By
taking the forward rate into consideration, the investor will be able to know the total
returns that can be earned on securities denominated in different currencies, which will
enable him to invest where his returns are maximized.

Assume that the domestic currency is ‘A’ and the foreign currency is ‘B’. An investor can
earn a return of RA on domestic deposits, and a return of RB on the foreign currency
denominated securities. For making an investment in the latter, the investor will have to
first convert his holdings in domestic currency A into foreign currency B. Let the spot
rate at which this conversion takes place be S(A/B). At the same time, let the relevant
forward rate be F(A/B). For every unit of home currency A, the investor will get
1/S(A/B) units of foreign currency B. This, when invested, will at the end of one year
give

1/S(A/B) x (1+RB) units of foreign currency B.

These, when converted at the forward rate, will give

F(A/B)
x (1+RB) units of home currency A
S(A/B)

At the same time, an investment in the domestic currency will, at the end of one year,
give

(1+RA) units of home currency A.

Now suppose that

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F(A/B)
(1+RA) > x (1+RB)
S(A/B)

In such a case, investors will prefer to invest in securities denominated in home currency
A rather than in foreign currency B, as it would fetch them higher return. If the opposite
were true, i.e.

F(A/B)
(1+RA) < x (1+RB)
S(A/B)

the investors will prefer to invest in securities denominated in foreign currency B.

The investor will be indifferent as to the choice of the currency only if

F(A/B)
(1+RA) = x (1+RB) (1)
S(A/B)

i.e. if the returns on both investments were equal.

The above equation is a formal statement of interest rate parity theorem.

Formal statement of interest rate parity theorem

In the absence of restrictions on capital flows and transaction costs, for any pair of
currencies A and B, the following relation must hold:

F(A/B)
(1+RA) = x (1+RB)
S(A/B)

Where RA and RB are annual interest rates on investment in currencies A and B

respectively and F(A/B) is one year forward rate and S(A/B) is the spot rate.

The above equation (1) can be rewritten as

(1+RA) F(A/B)
= (2)

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(1+RB) S(A/B)
Or,

F (A/B) (1+RA)
= (3)
S(A/B) (1+RB)

The above equation represents covered interest parity condition

Interest rate parity theorem can also be stated in another form.

By subtracting 1 from both sides of equation 2 we have,

(1+RA) F(A/B)
- 1 = - 1
(1+RB) S(A/B)

Or,

(1+RA) (1 + RB) F(A/B) S(A/B)

- = -
(1+RB) (1 + RB) S(A/B) S(A/B)

ie.,

(1+RA) - (1+RB) F(A/B) – S(A/B)

=
(1+RB) S(A/B)

ie.,

(1+RA) – 1-RB F(A/B) – S(A/B)

=
(1+RB) S(A/B)

Or,

(RA – RB) F(A/B) – S(A/B)

= (4)
(1+RB) S(A/B)

Equation (4) above is another way of stating interest rate parity theorem.

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The right-hand side of equation (4) is the forward premium on the foreign currency and
the numerator of left-hand side is the interest differential between the home currency and
foreign currency.

So this form of interest rate parity theorem states that the forward premium or discount
between two currencies is equal to the interest rate differential between those currencies.

This interest rate parity condition will be more evident by making the following
approximation.

When the interest on the foreign currency investment is small and can be ignored, the
above equation (4) can be approximated as,

F(A/B) – S(A/B)
RA – RB = (5)
S(A/B)

That is, the forward premium or discount between two currencies is equal to the interest
rate differential between those currencies.

When IRP holds, an investor will be indifferent between investing in securities

denominated in the two currencies. However, if IRP is violated, an investor would prefer
one security to another.

Formal statement of Interest rate Parity theorem

In the absence of restrictions on capital flows and transaction costs, for any pair of
currencies A and B, the following relation must hold:

F(A/B)
(1+RA) = x (1+RB)
S(A/B)

Or,

The forward premium or discount between two currencies is equal to the interest rate
differential between those currencies. i.e.,

F(A/B) – S(A/B)
RA – RB =
S(A/B)

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IRP represents an arbitrage equilibrium condition that should hold in the absence of
barriers to international capital flows. If IRP is violated, one can lock in guaranteed profit
by borrowing in one currency and lending in another, with exchange risk hedged with a
forward contract. As a result of this covered interest arbitrage, IRP will be restored. IRP
implies that the exchange rate depends on the relative interest rates between two
countries. A higher (lower) domestic interest rate will lead to appreciation (depreciation)
of the domestic currency.

Departure from Interest Rate Parity

Interest Rate Parity holds good only in the absence of :

 Transaction costs
 Political Risk
 Taxes and
 Capital Controls

Transaction costs: In practice, transaction costs cause a departure from interest rate
parity. Transaction costs are incurred in forex market and money market. The transaction
cost involved in money market operations is the difference between the investment and
borrowing rate. In the foreign exchange markets the transaction costs are in the form of
bid-ask spreads, in addition to brokerage fees, transmission costs, transaction taxes, etc.

Political Risk: Political risk is the risk of any change in the foreign country’s laws or
policies that affect the returns on the investment. It may take the form of a change in the
tax structure or a restriction on repatriation among other things. This additional risk
makes the investors require a higher return on foreign investments than warranted by the
interest parity. This factor allows deviations from the parity to take place.

Taxes: Taxes can affect the parity in two ways – through withholding taxes and through
differential tax rates on capital gains and interest income.

Capital controls: This is the most important cause of the large deviations from covered
interest parity. Capital controls include restrictions on investing or borrowing abroad and
on repatriation of investments made by foreign residents. It also includes restriction on
conversion of currencies. These controls restrict the market forces from bringing the
interest rates and exchange rates in line with the parity.

Covered Interest Arbitrage

The interest rate parity theorem states that, in the absence of restrictions on capital flows
and transaction costs, for any pair of currencies A and B, the following relation must
hold:

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F(A/B)
(1+RA) = x (1+RB) (Eq.1)
S(A/B)

Where RA and RB are annual interest rates on investment in currency A and currency B
respectively and F(A/B) is one year forward rate and S(A/B) is spot rate.

If the above equation does not hold good, an arbitrageur can make riskless profits by
borrowing in the cheaper currency and investing in the costlier one, using the forward
market to lock-in his profits.

Now suppose that

F(A/B)
(1+RA) > x (1+RB) (Eq.2)
S(A/B)

Then, the arbitrageur would borrow in foreign the currency, convert the receipts to the
domestic currency at the ongoing spot rate, and invest in the domestic currency
denominated security, while covering the principal and interest from the investment at the
forward rate. At maturity, he would convert the proceeds of the domestic investment at
the prefixed forward rate and pay-off the foreign liability, with difference between the
receipt and payments being his profit.

Now suppose that

F(A/B)
(1+RA) < x (1+RB) (Eq.3)
S(A/B)

Then, the arbitrageur would borrow in the domestic currency, convert it into foreign
currency at the spot rate, invest the proceeds in foreign currency denominated securities,
and cover the principal and interest from this investment at the forward rate. At maturity,
he would convert the proceeds of the foreign currency investment at the prefixed forward
rate and pay-off the domestic currency liability, the difference between the receipt and
payments being his profit.

This process of borrowing in one currency and simultaneously investing in another, with
the exchange risk hedged in the forward market is referred to as covered interest
arbitrage.

Thus, it follows that, unless equation (1) above holds good, arbitrageurs would be
borrowing in one currency and investing in another to earn riskless profit. These activities
of a large number of arbitrageurs would result in the forex markets and money markets
getting affected in a manner that makes the interest rates and exchange rates adjust, so

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that Eq.1 becomes true. For example, if Eq.2 holds good, the above mentioned arbitrage
activities would result in:

 Foreign currency interest rate going up as a result of increased borrowing in

that currency;
 Domestic interest rate falling as a result of increased investments in the
currency;
 The spot rate falling due to increased supply of foreign currency in the spot
market.
 The forward rate increases due to increased demand for the foreign currency
in the forward market.

This process will continue till the inequality is removed and Eq.1 is satisfied.

The covered interest arbitrage process discussed above makes the following assumptions:

 That there is no transaction costs both in forex market and money market
 That there is no restriction on capital flows
 That there is no taxes

The Fisher Effect (or Fisher’s Closed Proposition or Fisher Hypothesis)

The interest rates used in day-to-day financial transactions are known as nominal interest
rates. The nominal interest rate is the rate of exchange between current money and future
money. For example, suppose an investor has deposited Rs. 100 with a bank today. So his
current money is Rs. 100. Assume that after one year he gets Rs. 110 with interest from
the bank. This Rs. 110 is his future money. So his rate of exchange between current
money and future money, which is the nominal interest rate, is 10% [((110-
100)/100)*100]. Irving Fisher, who formulated the Fisher Hypothesis, states that this
nominal interest rate consists of two components: the real rate of interest and the
expected rate of inflation. Thus according to Fisher, The nominal interest rate is the sum
of the real interest rate and the expected inflation rate. In other words, the real interest
rate is the nominal interest rate adjusted for inflation. The Fisher hypothesis can be easily
understood from the following example.

Suppose you have Re 1.00 to invest. The bank is promising 8% per annum on a one year
deposit. Obviously you will be receiving Rs. 1.08 after one year. So your wealth has
increased from Re 1.00 to Re. 1.08. But your real increase in wealth depends upon the
purchasing power of money or inflation after one year. The inflation erodes the wealth. If
the inflation is less than 8% for the year, obviously your wealth has increased in real
terms. On the other hand, if the inflation is more than 8%, your real wealth has decreased
from Re. 1.00 in one year. In order to induce you to invest, the bank has to promise a rate
of return which should include the expected rate of inflation. Thus the nominal rate of
return promised by the bank has two components: The real rate of return, which is the
reward for waiting, and the expected rate of inflation.

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Interest is the reward paid to the investor for waiting. It is an addition to the wealth of the
investor. But this addition to the wealth of the investor will be eroded by the inflation.
The nominal interest rate, since it includes inflation, does not represent the real increase
in wealth of the investor. The real increase in wealth of an investor is represented by the
real interest rate. So investors are interested in real interest rate and not in nominal
interest rate. It is the real interest rate which provides the reward for waiting. Assuming
that there is no restriction in the international mobility of funds, the real interest rate
should be the same in different countries. Or else, arbitrage in the form of international
capital flows will drive the interest rates to equality.

The Fisher Effect states that the nominal interest rate is the sum of the real interest rate
and the expected inflation rate.

Mathematically, the fisher hypothesis can be represented as:

(1 + Nominal interest rate) = (1 + Real interest rate) x (1 + Expected rate of inflation)

Let ‘ k’ be the nominal rate of interest, ‘r’ be the real rate of interest, and’ i’ be the
expected rate of inflation. Then,

(1+k) = (1+r) x (1+i)

Solving for the nominal rate of interest, we get:

k = r + i + ri

If real interest rates and inflation rates are low, ‘ri’ will be negligible and can be ignored.
In that case, the above equation can be modified as:

k = r+i
That is,

Nominal interest rate = real interest rate + expected rate of inflation.

The above equation represents the Fisher Effect.

The International Fisher Effect (or Fisher’s Open Proposition)

The Fisher’s closed proposition formally states that:

(1+k) = (1+r) (1+i)

where ‘ k’ is the nominal rate of interest, ‘r’ is the real rate of interest, and’ i’ is the
expected rate of inflation.

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If kh represents the nominal interest rate in home country, rh represents the real interest
rate in home country and ih represents the inflation in home country, then

(1+kh) = (1+rh) (1+ih) (Eq.1)

Similarly, if kf represents the nominal interest rate in foreign country, rf represents the real
interest rate in foreign country and ih represents the inflation in foreign country, then

(1+kf) = (1+rf) (1+if) (Eq.2)

Dividing equation 1 by equation 2 we get,

(1 + kh) (1+rh) (1+ih)

= (Eq.3)
(1 + kf) (1+rf) (1+if)

According to the law of one price, the real interest should be the same across different
countries. So, if the law of one price holds good for real interest rates in two different
countries, then rh should be equal to rf and the real interest rates rh and rf cancel from the
right hand side. Then, equation 3 reduces to:

(1 + kh) (1+ih)
= (Eq.4)
(1 + kf) (1+if)

The above relation is called the International Fisher Effect or Fisher’s Open
Proposition.

The international Fisher effect states that the nominal interest rate differential is equal to
the inflation rate differential.

International Fisher effect can also be stated in another form.

We know that, according to the relative form of PPP, the inflation rate differential is equal
to the change in exchange rate. At the same time, the inflation rate differential is also
equal to the nominal interest rate differential. So, we can conclude that the nominal
interest rate differential is equal to the change in exchange rate. This is another way of
stating international Fisher effect.

So, international Fisher effect also states that the nominal interest rate differential is equal
to the change in exchange rate.

Formal statement of International Fisher Effect

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The international Fisher effect states that the nominal interest rate differential is equal to
the inflation rate differential. i.e.,

(1 + kh) (1+ih)
=
(1 + kf) (1+if)
Or,

The nominal interest rate differential is equal to the change in exchange rate.

Factors Influencing Exchange Rates

Exchange rate is the price of a currency in terms of another currency. As in the case of
commodities, the price of a currency is influenced by the demand and supply of the
currency. There are several factors that influence the exchange rate through their effects
on a currency’s demand and supply. Some of the factors affecting the exchange rates are:
1. Relative Inflation Rates: Changes in relative inflation rates can affect
international trade, which in turn would influence the demand and supply of
currencies and exchange rates. Inflation affects the exchange rates by affecting
the competiveness of one country’s goods against the goods of another country.
In view of inflation, a country’s products may become more expensive leading to
a decline in its export. This decline in export would result in a decline in the
supply of the foreign currency thereby leading to a change in exchange rate.
Currency of a country, whose expected inflation rate is higher than that of other
countries, is likely to depreciate.
2. Relative Interest Rates: Changes in relative interest rates affect investment in
foreign securities, which in turn will influence the demand and supply of
currencies and the exchange rates. Thus, the interest rates in the economy also
influence the exchange rate through supply and demand of foreign exchange.
When the interest rate in an economy rises, foreign currency flow to that country
will increase as investors find it an attractive place to invest. This would result in
an increase in supply of the foreign currency in the economy leading to an
appreciation of domestic currency. Similarly, if interest rates in other countries
rise, there will be a flight of capital and foreign currency from the country
leading to a depreciation of the domestic currency.
3. The Economic Growth rate: A country’s economic growth rate influences the
demand and supply of foreign currency. Economic growth of a country is an
important of cross border equity investment and foreign direct investment.
Further, the higher the economic growth rate, the more will be the economic
transactions, both within the country and across countries. This will cause
outflow and inflow of foreign currency leading to a change in exchange rate.
4. Balance of Payments: A country’s balance of payments can have significant
influence on its exchange rate. Transactions affecting the balance of payments

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can affect the demand and supply of foreign exchange and thus has an influence
on the exchange rate. While an adverse balance of payments will lead to
depreciation in the value of a currency a favorable balance payments will result in
an appreciation of a currency.
5. Market Expectations: Another factor influencing exchange rates is market
expectations of future exchange rates. Like other financial markets, foreign
exchange markets also react to any news that may have a future effect on the
exchange rates. For example, news of potential increase in U.S. Inflation may
cause currency traders to sell dollars, anticipating a future decline in the dollar’s
value.
6. Foreign Exchange Reserves: A large amount of foreign exchange reserves will
strengthen the home currency. Any fall in foreign exchange reserves through
continuous deficit in external account balances will weaken the home currency.
7. Capital Market Liquidity: Capital market liquidity is particularly important to
foreign institutional investors. High liquidity in capital market will attract more
foreign institutional investments, which in turn, would affect the exchange rates.
8. Speculation: Speculation can both cause a foreign exchange crisis or make an
existing crisis worse. Speculation has contributed greatly to the emerging market
crises in the past. Some characteristics of speculation are hot money flowing into
and out of currencies, securities, real estate, and commodities.
9. Political factors: Political factors do influence the demand and supply of foreign
currency. Political stability in the country may attract large amount of investment
funding in foreign currencies as investors may find the country to be less risky
and more rewarding. On the other hand, any political instability of a country may
drive away investors from the country and cause an outflow of foreign funds to
other economies. Thus the political factors in the country may influence the
exchange rate through the supply and demand for foreign currencies.
10. Social Factors: The demand and supply of foreign currency, as well as foreign
exchange rate, are also influenced by social factors like literacy, education levels,
communal and religious harmony and demographic characteristics. For example,
communal and religious harmony may attract large foreign investments.
11. Government Controls: Government may impose several controls and barriers
on imports, exports, remittances, and investments. All such controls influence
demand and supply of currencies on the foreign exchange market. Government
may also directly intervene in the foreign exchange market and influence
exchange rates. Therefore exchange rates are highly susceptible to government
controls, barriers and intervention.

International Finance DCMS Module I