Currency Exchange Rate Theories

Currency exchange rate theories explain how the value of one country's currency compares to another. The purchasing power parity (PPP) theory suggests exchange rates adjust over time to equalize the cost of goods across countries, reflecting inflation differences. The interest rate parity (IRP) theory states that forward exchange rates reflect interest rate differentials between countries, preventing arbitrage. The balance of payments approach considers a country's trade and financial flows; large deficits may weaken its currency. Together, these theories help understand fluctuations driven by inflation, interest rates, trade balances, and investor expectations.