Optimal Exchange Rate Beyond Purchase Power Parity


The value of a currency stems from its power to purchase a basket of goods and services. The exchange rate
between two currencies is their relative value, which by conventional wisdom is determined via the well-known
purchase power parity (PPP) theory. But the PPP can be valid only when there is free exchange of capital, labor,
material and services across national boundaries. With barriers to free exchange, the PPP cannot be the sole basis of
determination of optimal exchange rates.

This paper expounds a novel theory in which banking and social instabilities play crucial roles in determining
the optimal exchange rate of a currency. By this theory, a lower currency value attracts sufficient global business
enterprises to create new jobs in a country. But keeping the currency value too low leads to excessive creation of
fiat money for the exporters and expatriates. The excessive money in the system may induce banks to relax
standards for lending to frivolous projects that may yield little returns. The projects may yield little returns because
they are likely to be promoted by the kith, kin and cronies of government officials who create the money and
oversee the banking system. An increased likelihood of frivolous lending (which is testable) can raise the quantum
of nonperforming loans which may lead to instability in the banking system. The excess money created, due to low
currency values, for a small segment of people (exporters and expatriates) of the country may likely generate
(testable outcomes like) wealth disparity and hence social instability. The optimal exchange value of a currency
should thus be determined by balancing growth in jobs with rising social and banking instability.

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