Exchange Rates Linked to Inflation: Purchasing Power
The relationship between currencies defined by relative inflation levels is primarily explained by the theory of Purchasing Power Parity (PPP).
Understanding Purchasing Power Parity
- Purchasing Power Parity (PPP) theory suggests that exchange rates between currencies should equalize the prices of an identical basket of goods and services in any two countries.
- In simpler terms, if inflation is higher in one country compared to another, its currency's purchasing power decreases, leading to a depreciation in its exchange rate against the other currency.
- This concept directly links the relative inflation rates of countries to their exchange rate movements.
Analysis of Options
- Fixed Rate: This is an exchange rate set by government policy and is not determined by relative inflation.
- Floating Rate: While influenced by inflation, a floating rate is determined by supply and demand in the foreign exchange market. It's not solely defined by relative inflation.
- Purchasing Power: This concept is the foundation of PPP theory, which explicitly defines the exchange rate based on relative inflation and the resulting changes in the value of money.
- Interest Rate: Interest rates affect capital flows and exchange rates but do not define the relationship based on relative inflation itself.
Therefore, the standpoint defining the relationship between currencies based on relative inflation is Purchasing Power.
Important Questions from Foreign exchange market
In which year did the companies IBM and Coca Cola shut down their operations for not being able to comply with the Foreign Exchange Regulation Act that mandated foreign investors cannot own over 40% in Indian enterprises?
Identify the drivers for increased Foreign Institutional Investment flows in Indian stock markets in recent times
A. Covid-19 pandemic driven liquidity outflows from the western capital markets
B. Geopolitical supply chain relocations
C. Increased India weightage in MSCI Emerging Market Index
D. Steep decline in interest rates in large market friendly economies
E. Favourable risk-reward ratios in Indian stock markets
Choose the correct answer from the options given below:
Which of the following constitutes Foreign Direct Investment?
Arrange the following modes of entry in foreign markets starting with the mode of entry having least commitment, risk, control and profit potential:
(A) Company hires a local manufacturer to produce the product.
(B) Company starts exports working through domestic export agents and exports management companies.
(C) Company joins hands with local investor and forms a company in which both share ownership and control.
(D) Company starts export using domestic export department and overseas sales branch.
(E) Company offers a complete brand concept and operating system to an investor in return of certain fee.
Choose the correct answer from the options given below:
Given below are two statements: One is labelled as Assertion A and the other is labelled as Reason R.
Assertion (A): Sustained current account surplus encourages the government to liberalize imports and capital movements.
Reasons (R): The current account and balance of payments positions of a country can significantly influence its economic policies.
In the light of the above statements, choose the correct answer from the options given below:
