Estimate the equilibrium exchange rate based on Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) theories.
Amount of Currency A to buy 1 unit of Currency B
Calculation Results
Implied PPP Rate (Long Term):–
Currency Valuation Status:–
Interest Rate Differential:–
Implied Forward Rate (IRP):–
function calculateRateDynamics() {
// Retrieve inputs
var domPrice = parseFloat(document.getElementById('domPrice').value);
var forPrice = parseFloat(document.getElementById('forPrice').value);
var domInt = parseFloat(document.getElementById('domInt').value);
var forInt = parseFloat(document.getElementById('forInt').value);
var spotRate = parseFloat(document.getElementById('spotRate').value);
// Validation
if (isNaN(domPrice) || isNaN(forPrice) || isNaN(domInt) || isNaN(forInt) || isNaN(spotRate)) {
alert("Please enter valid numeric values for all fields.");
return;
}
if (forPrice === 0) {
alert("Foreign price level cannot be zero.");
return;
}
// 1. Purchasing Power Parity (PPP) Calculation
// PPP Rate = Domestic Price / Foreign Price
var pppRate = domPrice / forPrice;
// 2. Valuation Calculation
// Percentage difference between Spot Rate and PPP Rate
// If Spot > PPP, Currency A is undervalued relative to PPP (it takes more A to buy B than implied)
// Or simplified: How far is the current market from the theoretical PPP?
var valuationDiff = ((spotRate – pppRate) / pppRate) * 100;
var valuationText = "";
if (valuationDiff > 0) {
valuationText = "Foreign Currency Overvalued by " + valuationDiff.toFixed(2) + "%";
} else {
valuationText = "Foreign Currency Undervalued by " + Math.abs(valuationDiff).toFixed(2) + "%";
}
// 3. Interest Rate Parity (IRP) Calculation
// Forward Rate = Spot Rate * ((1 + i_dom) / (1 + i_for))
// Note: Interest rates are usually annual, assume period T=1 for simplicity or raw rate input
var domMultiplier = 1 + (domInt / 100);
var forMultiplier = 1 + (forInt / 100);
var forwardRate = spotRate * (domMultiplier / forMultiplier);
var intDiff = domInt – forInt;
var diffText = intDiff.toFixed(2) + "%";
// Display Results
document.getElementById('pppResult').innerText = pppRate.toFixed(4) + " A/B";
document.getElementById('valuationResult').innerText = valuationText;
document.getElementById('diffResult').innerText = diffText;
document.getElementById('irpResult').innerText = forwardRate.toFixed(4) + " A/B";
// Show results container
document.getElementById('results').style.display = "block";
}
Flexible Exchange Rate Systems: Calculated According to What?
In the world of international finance, understanding how flexible exchange rate systems are calculated is crucial for investors, economists, and policymakers. Unlike fixed exchange rate systems, where a central bank pegs the currency value to another currency or a basket of assets, a flexible (or floating) exchange rate system is determined by the open market.
The Core Determinant: Supply and Demand
Fundamentally, a flexible exchange rate is calculated according to the forces of supply and demand in the Foreign Exchange (Forex) market. There is no single equation used by a government official to set the price. Instead, the "calculation" is a continuous, real-time discovery process where millions of transactions determine the equilibrium price.
Supply: When a country imports goods or invests abroad, it sells its domestic currency to buy foreign currency, increasing the supply of the domestic currency.
Demand: When foreign entities buy domestic exports or invest in the domestic economy, they must buy the domestic currency, increasing demand.
Theoretical Calculation Models
While the market sets the price dynamically, economists use specific mathematical models to calculate where the exchange rate should theoretically be. These models help determine if a currency is overvalued or undervalued.
1. Purchasing Power Parity (PPP)
The PPP theory suggests that exchange rates between two currencies are in equilibrium when their purchasing power is the same in each of the two countries. This is often calculated using the "Big Mac Index" or a basket of goods.
The Formula: S = P1 / P2
Where S is the exchange rate, P1 is the cost of goods in domestic currency, and P2 is the cost in foreign currency.
2. Interest Rate Parity (IRP)
This model connects interest rates, spot exchange rates, and foreign exchange rates. It suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies. If one country has a higher interest rate, its currency is expected to depreciate against the currency with the lower interest rate to offset the investment advantage.
Key Factors Influencing the Calculation
In a flexible system, the market continuously recalculates the rate based on several macroeconomic variables:
Inflation Rates: Generally, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.
Interest Rates: Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
Current Account Deficits: If a country spends more on foreign trade than it earns, it supplies more of its own currency than foreigners demand, lowering its value.
Public Debt: Large-scale deficit financing can encourage inflation, and if perceived as unsustainable, can lead to capital flight and currency depreciation.
By using the calculator above, you can simulate how differences in price levels (PPP) and interest rates (IRP) theoretically influence the valuation of a currency pair in a flexible exchange rate system.