Home Blog Dollar Value Appreciation: Economic Models’ perspective

Dollar Value Appreciation: Economic Models’ perspective

Uttam Kumar Gulshan, FMS Delhi, 2017-19

Dollar Value appreciation has not been a recent phenomenon. However, the recent appreciation in the value of the dollar has been a piece of breaking news because of several reasons. 

  1. The huge jump in the value of the dollar was not expected.
  2. People expected that the Government or the Central Bank would do something to help the Rupee’s condition.
  3. Mechanisms implemented have not been fully successful to bring back the rupee to its previous level.

The fiscal or monetary policies implemented so far has worked well with the inflation targeting in India. However, more or less, the actions to check the fall of the rupees has not been very effective. People sending remittances to the home country, India, in US Dollars must be happy with such appreciation as the converted value would be high. However, it becomes a headache for people who travel outside India where they require US Dollars, as ultimately, they would have to burn more cash to get the same value of dollars.

Economists have been studying various phenomena to identify and implement models that could justify the fall or rise of the value of one currency with respect to the another. There have several economic models that have proposed so far. The models include the Purchasing Power Parity Theorywhich is based on the purchasing powers of the two countries, Interest Rate Parity Theory which is based on the interest rates of the two countries involved, International Fischer Effect which is based on nominal interest rates or inflation rates of the two countries, and Balance of Payments Theorywhich is based on the surplus or deficit of the account, i.e., in order to reach equilibrium, it must be balanced. There are few other theories which include Real Interest Differential Model, Asset Market Model, Monetary Model, and Economic Data model.

The focus of this paper is to discuss models that can provide quantitative methods to estimate future exchange rates. Accordingly, some of the models listed above have been discussed in the subsequent sections.


The relative importance of various determinants affecting the exchange rate is highly debatable because there is no fool proof method of determining which factor affects the most. However, trade between two countries does affect the exchange rate to a substantial level. Let us look at some of the factors which can possibly affect the USD-INR exchange rates.

1. Differentials in Inflation

A country having a lower rate of inflation typically, should show a rising value of its currency and it is true for US Dollars. Since the US Dollars is affected by the inflation rate in USA and INR by the inflation rate in India, it can be said that US Dollars is more likely to rise compared to INR. The CPI Data[1]taken from August 2008 to September 2018shows that the average inflation level of India has been higher than that of the USA. In fact, USA suffered from deflation in the year 2009. However, India was having monthly CPI inflation of as high as 11.72%in August 2009. Perhaps the financial crisis affected India quite heavily. However, the value of INR per USD changed from Rs. 46.105 to Rs. 44.57.

2.Differentials in Interest Rates

The interest rates of the two countries are quite correlated to the rate at which the exchange rate between two currencies is fixed. Changing interest rates indirectly indicates the rate of inflation in the economy and perhaps this is the reason why it is taken into account for determining the exchange rate movements. In fact, some of the economic models use interest rates instead of inflation rates to determine the forward rates and future exchange rates.

Also, higher interest rates increase the chances of inflow of foreign capital and thus influencing the mobility of the foreign currency and the exchange rate. However, with higher inflation, the exchange rate will be negatively affected. 

The Interest Rate Data[2]taken from the period of August 2007 to October 2018 shows that the interest rate in August 2007 was 7.75 % which rose to 9.00 % in October 2008, fell to 4.75% in July 2009, rose again to 8.50% in January 2012, went down to 6.00% in October 2017 and reached 6.50% in October 2018. Overall the rates have declined over the longer period of time.

3. Current Account Deficits

Current account deficit shows the balance of trade between two countries or trading partners. It includes various items which can be tangible or intangible. Higher imports imply a deficit whereas higher exports imply a surplus. In any of the cases, a huge difference suggests an imbalance in the foreign trade thereby affecting the exchange rates.

The data on statista.com[3]shows that India’s current account has been in deficit for the past 10 years with highest being in 2012 with 192.87 billion USD of the deficit.The deficit had been declining in the past from 2012 to 2016 and it rose again in 2017.

4. Public Debt

Countries engage in public sector projects which can boost the economy and help in the growth of the country. However, huge debt can increase inflation and reduce foreign investments which may cause an imbalance in the foreign exchange value.

Government sells bonds and use other measures to repay the debt. They can also sell securities outside of the country. However, if the risk of default is high, people will not invest in it. Thus, debt plays an important role in exchange rate determination.

India’sPublic debt to GDP ratiodata[4]shows that India’s public debt’s value is almost 70% of the GDP, which is a huge number. However, this ratio is even higher for USA which has the ratio of more than 100% of the GDP.[5]

5.Political Stability and Economic Performance

Often investors look for countries with a more stable economy and growth potential where they can invest. The USA is considered more economically advanced and often categorised as a developed nation whereas India is still a developing country. 

Certain credit rating agencies have been rating countries on the basis of their outlook about a country. Global rating agencies are predominantly dominated by S&P, Moody’s and Fitch. 

India’s local and foreign currency issuer ratings are Baa2[6]in both cases by Moody’s whereas it is AAA for the USA[7].


Now, coming to the Economic models which were enlisted at the beginning, it can be seen that some of them employ one or more of the aforementioned factors to predict the exchange rates. Some of these models show that the value of the dollar with respect to the rupees was bound to appreciate. But by how much and in what time, it must be identified. In order to check the value of the same, I took monthly USD-INR exchange rates from December 2007 to November 2018which covers almost 10 years.[8]

Let us apply some of these economic theories on the data given to check if they really hold true or not. 

1.Purchasing Power Parity Theory (PPP)

The PPP theory applies to commodities. PPP states that there is a link between prices in two countries and the exchange rate between the currencies of both the countries.

The theory makes three assumptions:

  • There are no transportation costs for transporting a commodity from one country to another (transportation costs are zero).
  • There are no costs for converting one currency into another (currency conversion costs are zero).
  • There are no restrictions on the movement of commodities between countries. That is, there are no trade barriers or quotas.

According to the Law of one price, the price of an identical product has an equivalent value in both countries which are compared else the violation of the law of one price occurs and arbitrage opportunities arise. Thus, the price of a commodity should be such that the ratio of the currency values should be equal to the ratio of the commodity prices. 

However, this does not hold true in an absolute sense as shown in the figure given below.

Fig 1.: PPP and the USD-INR values

The INR per USD is way above the PPP ratio of the countries. If we assume that we have a factor F which is constantly associated with the PPP values of the country, we get the following data.

Fig 2: Predicting USD-INR values using PPP and a multiplicative factor F.

The factor F = INR per USD / Ratio of PPP of INDIA to US, e.g. for 2017, PPP(US) = 1, PPP(INDIA) = 17.67, ratio (PPP) = 17.67 and Factor F = 67.515/17.767 = 3.800.

It can be seen from the data that factor F has consistent value with a mean of 3.50 and a standard deviation of 0.33. It clearly implies that the relation between the two has some relationship which is clearly very strong. 

The correlation coefficient between the two is 0.8638which shows that they are moderate to highly correlated.

2. Interest Rate Parity Theory (IRP)

The theory states that there is a link between the nominal interest rates in two countries and the exchange rate between their currencies. It is sometimes also called the covered interest parity theory.

The theory applies to financial securities, and it makes the following assumptions:

  • When a currency is converted into another, or when financial security is bought or sold, there are no costs involved. That is, transaction costs are zero.
  • Money can freely flow between both the countries and there is full mobility of capital.
  • An investor can choose to invest in domestic currency-denominated financial securities or foreign currency-denominated financial securities. A hedging mechanism can be formed through forward contracts.

Keeping the above assumptions in the mind, the theory states that the Forward or the Future spot rate depends on the current spot rate and the nominal interest rates of the two currencies. 

The forward rate is:

F = S * [ (1 + i1) / (1 + i2)]

Where F = Future Spot rate of currency 1 w.r.t. 2

S = current Spot rate of currency 1 w.r.t 2

I1 = Interest rate in country 1

I2 = Interest rate in country 2

Let us apply the formula to check if it holds true in case of the US dollar appreciation.

The formula of the first cell in the predicted value is like this: 

Value = B3*(1+(H2/100))/(1+(I2/100))

This value has been adjusted keeping in mind that the values predicted are on monthly basis and thus, they need to be adjusted for one month by dividing by 12. Thus, the value in the first cell of the next column which is ‘Predicted with Adjustment (WA)’ is given as below.

Value = B3*(1+(H2/1200))/(1+(I2/1200))

The empirical evidence suggests thatthe dollar value appreciation as per this theory was expected and is not unusual.

In this theory, if the equilibrium condition fails which is the change in the spot prices with an equivalent change in the interest rates, arbitrage opportunities arise. Thus, small arbitrage opportunities do arise in certain cases. However, more or less the theory looks strong enough to predict the same.

Fig 3: Predicting USD-INR values using Interest Rates 

3. International Fisher Effect (IFE) Theory:

It is also known as the uncovered interest parity theory. According to this theory, the expected spot rate and the forward rate will merge in the future as the actions of the participants will make them equal.Basically, it thrives on the assumptions of the efficient market hypothesis.

Condition 1: When the forward rate is greater than the expected spot rate.

The market participants will sell the dollar forward to earn profits. Thus, due to selling the forward rates would fall until it converges with the actual value. At this point, profit-making opportunities disappear, and as the theory states, the forward rate and the expected spot rate will be identical.

Condition 2: When the forward rate is less than the expected spot rate.

Market participants would start buying the forward rate in order to gain profits and the forward rate would rise unless it converges with the spot rate. At this point, profit-making opportunities disappear, and as the theory states, the forward rate and the expected spot rate will be identical.

The theory also implies that the real interest rates would continue to remain the same in the two countries as the rates depend on the inflation rates. The formula is given as below.

F = S * [ (1 + i1) / (1 + i2)]

Where F = Future Spot rate of currency 1 w.r.t. 2

S = current Spot rate of currency 1 w.r.t 2

I1 = Inflation rate in country 1

I2 = Inflation rate in country 2

It is very similar to the interest parity theory considering except that it depends on the inflation rates. Let us look at the predicted rates using the theory.

The data shows that the value when adjusted is closer to the predicted value. In fact, the values at the last of the column of diff1 & diff2 show average ofthe difference between the Predicted & ‘Predicted WA’ and the Actual values.

Diff1 = Predicted – Actual

Diff2 = Predicted WA – Actual

Fig 4: Predicting USD-INR values using inflation rates (part 1)

Fig 5: Predicting USD-INR values using inflation rates (part 2)

Thus, it can be said that with a minimal difference of 0.016, the adjusted inflation rate could predict the future value quite correctly.


From the perspective of the economic models, the empirical data suggests that the exchange rates can be predicted fairly accurately. Though the models have certain assumptions which may not hold true in all actual scenarios, still they are able to predict the rates quite accuratelyand with a minor adjustment in case of PPP. 

Thus, it can be said that economists, more or less, had already envisaged that this was going to happen. Though these models do not consider all factors and usually work on one of the factors, they are still able to do a good job in predicting the rates. However, predicting beyond the upcoming period would be both difficult and useless as future rates may change and expectations would change. Further, the models could be made more accurate by incorporating more macroeconomic variables.


  1. Geert Bekaert and Robert Hodrick (2012). International Financial Management.
  2. Columbia University and the National Bureau of Economic Research, Columbia. Pearson
  3. Source: https://www.statista.com/statistics/271319/national-debt-of-india-in-relation-to-gross-domestic-product-gdp/
  4. Source: https://www.statista.com/statistics/269960/national-debt-in-the-us-in-relation-to-gross-domestic-product-gdp/
  5. http://pib.nic.in/newsite/PrintRelease.aspx?relid=173609
  6. https://www.reuters.com/article/us-moody-s-usa/moodys-affirms-united-states-top-notch-credit-rating-idUSKBN1HW2Y8
  7. Source: in.investing.com

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