Answer to Question #99046 in Macroeconomics for jemine

Question

evaluate foreign exchange rate theories and its effect on naira exchange rate

Answer 1

Purchasing power parity (PPP) The theory of purchasing power parity says that the same amount, converted at the current rate to national currencies, can be used to purchase the same goods in different countries. The basis of this theory is the idea that the same product should have the same price throughout the world. If, after conversion at the current exchange rate, the price of the same product in the two countries is significantly different, the possibility of arbitration arises, since the product will be bought in the country where it costs less.

Interest rate parity The theory of interest rate parity is similar to the theory of purchasing power parity and consists in the fact that, with equal risks, investments in assets located in two countries should bring the same income, otherwise arbitrage arises. This theory is also based on the law of a single price, since the purchase of a security in one country should bring the same profit as the purchase of the exact same asset in another country; otherwise, the exchange rate must be adjusted.

International Fisher Effect According to this theory, a change in the exchange rate between two countries should correspond to the difference between the nominal interest rates of these countries. If the nominal interest rate in one country is lower than in another, then the price of the currency of a country with a low interest rate should be adjusted relative to the price of the currency of a country with a high interest rate by the value of this difference.

Balance of payments theory The country's balance of payments consists of two sections: current account and capital account, which reflect the outflow and inflow of goods and capital from and to the country. The balance of payments theory says that changes in the exchange rate depend on the trade balance, which is part of the current account.