THE THEORIES OF INTERNATIONAL PARITY AND THEIR RELATIONSHIP WITH THE

EXCHANGE RATE

By Jaime Lpez and Camilo Cotamo

University of Ibague
International Business Administration Program

Are the theories of parity good at predicting the exchange rate behavior? Yes, but only
under certain conditions and with the influence of some such factors as the inflation, arbitration
operations, interest rates, and investment flows among the countries, therefore the present text
has the purpose of determining if there are facts that demonstrate if the theories of parity can
predict the exchange rate to long or short term, for that which they will be explained by means of
examples or some authors' statements that sustained the form in which the exchange rate is
predicted. By this way we will observe as the inflation and the prices of goods and services
determine the exchange rate between two countries, on the other hand, The Parity of Interest
sustained how the differences among the nominal rates they determine the rate of change, and
how the arbitration of covered interest it achieves the objective of predicting the same one, lastly,
in the Theory of The International Fisher Effect will check if the differences among the interest
rates of two countries affect the exchange rate directly between two currencies.

According to the theory of The Purchasing Power Parity (PPP), proposal initially by
Cassel (1916, 1918) and reaffirmed by David Ricardo (1926) it sustains that the exchange rate of
a currency comes determined by the relative prices among countries. It is based on the idea that
the exchange rate moves long term so that it compensates the relative movements of national
prices, in few words that the level of prices in a certain currency of a country anyone spreads to
equal, long term, the levels of prices of the countries with those that it trades multiplied by the
exchange rate between its own currency and that of them.

An example of the Purchasing Power Parity will take it with the analysis of the exchange
rate peseta - dollar; we have that in the period 1974-1983 the rate of half variation of the
exchange rate peseta-dollar was of 7, 9% per year, being the half differential of inflation rate in
the period, 8, 9% and the half differential of rate of monetary expansion 8, 8% between both

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countries. That is to say that the PPP is still fulfilled certain approach when the variation of the
exchange rate has not been enough as to compensate the variations of the differential of prices.

Some specialists say that the PPP is completed mainly in the long term (Rogoff, 1996),
certain factors that can impede its such execution existing as: Restrictions to the trade, costs of
transport, interventions in the markets of foreign currencies or controls of changes; taking place
in the short term deviations of the market exchange rate on which would determine the parity of
prices. These deviations can take for a while more or less lingering to the nominal exchange rate
outside of the path of the relative prices. For the reestablishment of the PPP, Frankel (1986) it
sustains that, in occasions, the course of a ten year-old period is needed or more, after some
restriction led to the exchange rate outside of the path marked by the line of the relative prices.

The Parity of Interest theory supposes that the profitabilities that can be obtained in the
investments in two different countries should be same short term; it is the parity of interests the
one that should have bigger influence on the exchange rate. This demands that the exchange rate
differentials with cash and to term of our currency with the dollar, for example, spread to
compensate the differentials between the type of interest of the weight and the dollar for a
homogeneous and perfectly replaceable instrument among both currencies (for example, a short
term deposit).

So that the parity of interest rates is completed the arbitration of covered interest it is used
and it consists in an investment strategy in which requires to get in debt in a foreign currency, to
sell it in the market of counted, to invest that received to change and simultaneously to
repurchase the foreign currency of the loan in the long term market. This operation allows to
obtain a gain without assuming risk since the fluctuation of the exchange rate is covered for a
contract to term. If for example was pounds the foreign currency with which is lent and it is
repurchased it would make all the investors to want to buy the pounds to term, investing in
dollars and repurchasing the pounds in the future, that which would generate an appreciation
from the pound to future that would equal the yield of both investments disappearing the earnings
for arbitration.

The Theory of the Fisher effect created by Irving Fisher in 1930, sustains that the
relationship between the interest rate and the inflation is so strong that if the inflation, the interest
rate increases a same quantity it increased. The international focus of the same one affirms that
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the difference among the interest rates of two countries affected the exchange rate among the two
currencies, with base in that difference a calculation of the spot changes is obtained of each one.
This theory is completed since to the long term because in the short term it can have difficulties
due to the interventions of the government of each country through its economic politics,
although it is questioned by some economists that sustain that the interest and the inflation rates
are independent to each other, and totally hard to predict due to a great quantity of factors among
them, the work market, foreign currencies, imports, exports.

To conclude, the evidence empiric sample that, in the long term, the most inflationary
countries spread to have weak currencies, and the loss of value of its currency comes certain
fundamentally for the differential among the domestic and external inflation. It is necessary that
the countries look toward the exchange rate that grows to a quicker rhythm that the inflation of
the most competitive prices in their products. If the exchange rate grows to a slower rhythm that
that of the inflation, the country loses competitiveness. In fact, all the economies are sectors non
changeable that you grieve they have direct relationship with the international prices, however
the permanent movements of the rate of change can influence in the prices of the services,
through their influence on the prices of the inputs.

Bibliography

Cassel, G. (1921): The worlds Monetary Problems, Londres

Cassel, G. (1916): The Present Situation of Foreing Exchanges. The Economic
Journal, 26, 62-65.
Cassel, G. (1918): Abnormal Deviations in International Exchanges. The
Economic Journal, 28, 413-415.
Cassel, G. (1922): Money and foreign exchange after 1914, Constable and Co, Londres.
Cassel, G. (1924): The Purchasing Power Parity. Skandinaviska Kreditaktiebolaget, 68-70.
Frankel, J. A. (1986): International Capital Mobility and Crowding-out in the
U.S. Economy: Imperfect Integration of Financial Markets or of Goods
Markets? Hafer, R. W. (ed.): How Open is the U. S. Economy?, Lexington,
Mass, Lexington Books, 33-67.
Fisher, I. (1930), The theory of interest, New York
Keynes, J.M (1923): A tract on Monetary Reform, Londres
Ricardo (1926): Economic Essays, Londres
Rogoff, K. (1996): The Purchasing Power Parity Puzzle. Journal of Economic
Literature, 34, 647-668.
Villanueva, Javier (1985): Breve examen de las teoras relacionadas con la determinacin de la
tasa de cambio, Desarrollo Econmico, vol. 25, No 99(Oct Dec., 1985), pp.351 379, Jstor
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