Exchange rates are the price of a country’s currency in terms of another country’s currency. For example, the Japanese yen is pegged to the United States dollar which is known as the USD/JPY exchange rate. This in turn, means that exchange rates have two components, the domestic currency and a foreign currency, which can be quoted either directly or indirectly. A direct quotation is the price of a unit of foreign currency expressed in terms of a domestic currency, whereas, an indirect quotation is the price of 1 unit of domestic currency expressed in terms of a foreign currency. An exchange rate that does not possess the domestic currency as one of the two currency components is called a cross currency/cross rate which in turn is also known as a currency quotation, the foreign exchange rate or forex rate.
In the above diagram , an increase in demand for pound from the US shifts the demand curve to the right to D2 causing the pound to appreciate and the dollar to depreciate. An increase in the supply curve to the right meaning that there is an increase in the supply of pounds to the US market will cause a new equilibrium thus lowering the exchange rate; appreciating the dollar.
There are two parts to an exchange rate being the base currency and a counter currency. A direct quotation has the foreign currency is the base and the domestic currency is the counter whereas in an indirect quotation the domestic currency is the base and the foreign currency is the counter. Most exchange rates have the base currency as the United States dollar and other currencies as the counter currency; however, there are a few exclusions to this rule, as the euro and the Commonwealth currencies, for example, like the Britis...
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...e good in different nations. PPP is generally recognised to Cassell’s literatures in the 1920’s, however PPP origins can date back all the way to the 19th century British economist (David Ricardo 1821).
According to (Islam and Ahmed 1999) they identified that many researchers have conducted empirical tests to study the PPP relationship but the results have often been conflicting or different to one another. Furthermore, many of these studies have used unsuitable econometric methodologies and have used fairly short time periods to study what is tend to be known as a long-run relationship.
An extensive research has been carried out by (Taylor and Sarno, 1998), (Patel 1990) and (Dornbusch 1988) where all these papers studied the validity of PPP for the post-Bretton Woods floating exchange rates system and all failed to deliver sufficient evidence for long run PPP.
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