There are two theories used to explain the decision problem: 1. Theoretical PPP theory states that it should be based on the relative prices between countries, that is, the exchange rates of the two countries should be equal to the proportion of the price levels of the two countries (calculated through fixed contracts for goods and services).
Therefore, if prices rise or inflation occurs, the currency should depreciate and be compensated accordingly.
2. Exchange Rate parity theory The parity theory states that there should be arbitrage between exchange rates and interest rates.
This means that currency appreciation or depreciation should be offset by changes in interest rates.
For example, if it is higher than the interest rate, then it should fall against the yen according to interest parity theory.
The rationale is that investors need to be compensated by a fall in the exchange rate, since they have to pay interest to hold yen.
