Fluctuation in the expected exchange rate is caused by the new information of the fundamental influences which are received by the economy – these would include the imports, exports, interest rate which is relative to foreign investment rates. Thus it can be said that the expected exchange rate has a direct influence in determining or changing the real exchange rate. The variables such as import and export have certain expectations, this leads to an instant alteration of the expected exchange rate. The entire system works on assumptions, for example if traders hear that the rate of interest will be hiked next week, they buy dollars in a huge sum in hope of selling them off next week at a hiked price. This means that these traders assume an appreciation to occur and the value of dollar to increase. Therefore an expected rise in the value of the dollar in the future leads to an increase in its present value. This reduces the supply of the currency today and hikes the exchange rate. Hence as observed the exchange rate rises as soon as there is an expected rise.
The method of profiting involves arbitrage. Arbitrage is a tactical method by which goods and services purchased in one market are sold for a higher price in another market of a relative standard. This method of Arbitrage makes sure that the rate at which exchange occurs is same in two cities like for example London in UK and New York in America, as well as other trading centers. It is not possible to purchase at a low price in one city and sell for a hiked price in another. If this kind of sale was possible demand of the goods would be controlled and balanced to keep prices equal. Profit is also controlled by buying and selling in two different currencies. Arbitrage leads to parity of two kinds:
Interest Rate Parity
To understand interest rate parity an example would be ideal, let us assume that a bank deposit earns 5% in China and 3% in New York. Then it is obvious that the bank deposit would be shifted to China from New York. In fact loans could be taken from New York to invest in China. This kind of an approach is called the “Carry Trade”. However the parity occurs in the interest rate when the currencies of these two places, namely, China and New York differ. When the differences in the currencies are calculated it will be seen that the rate of interest which yields a certain amount is same in both the countries. Therefore interest rate parity can be understood as similar value of the interests which are earned across countries. This is balanced out keeping the risks in mind and the funds are often moved about to get the highest possible expected return. Again going back to the example of China and New York, if for a short time the rate of interest in New York rises and the value of dollar go up then the interest rates is balanced out.
Purchasing Power Parity
Let us try to understand purchase power parity through an example. If 100 yen equals to a dollar and a commodity costs 10000 Yen in Japan and $100 in America then the two commodities are of the same value. Therefore the same product can be easily purchased in both these countries for the same price. You could express the value either in dollar or yen and it would mean the same. The example shows equal value of money in different countries and this is what purchasing power parity seeks to denote. However there might not be a substantial harmony between the purchasing power of two countries. This implies that a commodity can be priced at an equal rate in two countries. For example, if the same commodity is priced at $110 instead of $100 and the exchange rate remains constant then to maintain parity the forces of arbitrage need to come to work. The solution would then be to raise the price of the commodity in Yen from 10000 yen to 11000 yen. Since the price is not at parity in the two countries a different approach is adopted to bring the parity in purchasing power.
Now if the value of commodities is rising only in one country while the price in the other country is static, like say prices rise in America but stay static in other parts, then the country where prices are rising will face a drop in foreign exchange market. This is also a way of ensuring parity where the exchange rate witnesses a drop. If US dollars are used as the example and the exchange rate of dollars faces a drop then there is a decrease in demand and increase in supply of the currency. Therefore since the demand falls and supply increases of the dollar it leads to restoration of the purchasing power parity. If the opposite happens and the prices of other countries increase while the dollar remains constant it leads to appreciation of the dollar. Here the demand of dollars increases while the supply witnesses a drop and exchange rate rises as per the expected rate. Till now the discussion has revolved around nominal exchange rate and the examples have illustrated buying one commodity of a certain currency using another. The next segment will deal the concept of real exchange rate.