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Financial Forces: Fluctuating Currency Values 219 International, a Missouri firm, were frozen and its principal charged with fraud under the CFTC’s Commodity Exchange Act. The CFTC’s website also warns potential investors of foreign exchange currency frauds they have uncovered, many online. CAUSES OF EXCHANGE RATE MOVEMENT Since 1973, the relative values of floating currencies and the ease of their convertibility have been set by market forces, influenced by factors such as supply and demand forecasts for the two currencies in question; inflation rates in the two countries; their relative productivity and unit labor cost; political developments such as unexpected election results; government fiscal, monetary, and currency exchange market actions; the two countries’ balance-of-payments accounts; and basic psychology.16 Monetary and fiscal policies of the government such as decisions on taxation, interest rates, and trade policies, and other forces external to the business such as world events, all may play significant roles. Monetary policies control the amount of money in circulation, whether it is growing, and, if so, at what pace. Fiscal policies address the collecting and spending of money by the government. While economists have not yet developed an accepted theory to explain exchange rate fluctuations, they have been able to identify several parity relationships among some of the factors that influence them. Parity relationships describe equivalencies, and two of these relationships, interest rate parity and purchasing power parity, are fundamental to our further consideration of exchange rates. They both rest on and are applications of the law of one price, which states that in an efficient market, like products will have like prices. If price differences exist, the process of arbitrage—simultaneous buying and selling to make a profit with no risk—will quickly close any gaps and the markets will be back at equilibrium. When the law of one price is applied to interest rates, it suggests that interest rates vary to take account of differing anticipated levels of inflation. The economic explanation of this relationship, which results in interest rate parity, is known as the Fisher effect. It states that the real interest rate will be the nominal interest rate minus the expected rate of inflation. Where the real rate of interest (rr) is equal to the nominal interest rate (rn) minus the expected rate of inflation (I ): rr = (rn) − I Thus, an increase in the expected inflation rate will lead to an increase in the interest rate. A decrease in the expected inflation rate will lead to a decrease in the interest rate. So, it makes sense that an investor would want to earn more in a high-inflation environment to compensate for the effect of inflation on the investment. An interesting application of the concept of interest rate parity, the international Fisher effect, says that the interest rate differentials for any two currencies will reflect the expected change in their exchange rates.17 For example, if the nominal interest rate in the United States is 5 percent per year and in the EU it is 3 percent, we would expect the dollar to decrease against the euro by 2 percent over the year or the euro to strengthen against the dollar by that same amount. A second important parity relationship is purchasing power parity (PPP). PPP is the amount of adjustment that must be made in the exchange rates for two currencies in order for them to have equivalent purchasing power. We use it to show the number of units of a currency required to buy the same basket of goods and services in two markets with different currencies. PPP is an application of the law of one price to a basket of commodity goods, and it suggests that for a dollar to buy as much in the United Kingdom as in the United States, the cost of the goods in the UK should equal their U.S. cost times the exchange rate between the dollar and the pound. This relationship is expressed in the following equation, where P is the price of a basket of commodity goods: £P($/£) = $P Another way to think about what PPP theory states is that currency exchange rates between two countries should equal the ratio of the price levels of their commodity monetary policies Government policies that control the amount of money in circulation and its growth rate fiscal policies Policies that address the collecting and spending of money by the government law of one price Concept that in an efficient market, like products will have like prices arbitrage The process of buying and selling instantaneously to make profit with no risk Fisher effect The relationship between real and nominal interest rates: The real interest rate will be the nominal interest rate minus the expected rate of inflation international Fisher effect Concept that the interest rate differentials for any two currencies will reflect the expected change in their exchange rates purchasing power parity (PPP) The amount of adjustment that must be made in the exchange rates for two currencies in order for them to have equivalent purchasing power


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