In normal course, nominal exchange rates change to reflect inflation-differentials. When nominal rates change and adjust in proportion to inflation-differentials, real exchange rates are maintained; these do not change.

However, very often there are fluctuations of bigger magnitude than warranted by inflation-differentials. Currencies continue to appreciate although purchasing power parity would warrant that the should depreciate (as happened to the Indian rupee vis-à-vis the American dollar in recent time). Such distortions are generally explained by two factors: (1) interest-rate differentials, and (2) ‘news’.

1.    Interest Rate Differentials and Exchange Rte Overshooting. A fundamental reason for the wide fluctuations is interest rate differentials. This phenomenon has been clearly observed in India in the recent years.

Interest rate difference between countries are caused by differences in their monetary and fiscal policies. International capital ahs a tendency to move to those countries where interest rates are relatively higher from those countries where they are low. This is because investors (generally large institutional investors) seek to place their funds where returns are highest. Capital inflows in foreign exchange will take place higher supply of foreign exchange in domestic market (which also means increase demand for domestic currency by the foretimes) will result in appreciation of domestic currency (which is the some as depreciation of foreign currency.)

While interest-rate-differentials persist, the exchange rate must deviate form its equilibrium of PPP value. This is called overshooting of exchange rates.

Illustration. Let us illustrate it with the help of an example. Suppose interest rates on financial investments in India are more than those in New York. The interest rate differentials will lead to a capital inflow into India. Investors in US dollar assets will sell these assets and buy assets in India. Demand for rupee will increase, whereas supply of dollars will inverse. The result would be that the price of rupee will go up and the price of dollar will go down; i.e., Indian rupee will appreciate whereas the American dollar will depreciate in value.

Interest-Rate-Differentials and Appreciation (Depreciation) of Currency. As long as interest-rate differentials last, capital inflows to the country with higher interest-rates would continue. Investors, where, do not take into account only interest-rate=differentials. Interest-rate differentials are combined with expected changes in exchange rates in future (defined as the period when the assets mature).

If a large inflow of dollars continues over a period of time not only domestic interest rates may be expected to fall, but the domestic currency may also depreciate; exchange rates may reverie back to their PPP equilibrium rte. Interest rate differentials may not be sufficient to sustain capital inflows.

For example, a 4 per cent interest-differential with an expected 4 per cent depreciation of domestic currency will leave the foreign investors indifferent toward domestic assets.

A 4 per cent interest differential with an expected 3 per cent depreciation of domestic currency will result in capital inflow.

Diagrammatic Representation of Exchange Rate Overshooting. The concept can be illustrated with the help of.

In the initial exchange rate is e₁. At time t₁ the central bank raises domestic interest rates; the exchange rate appreciates to e₂. Over time it then depreciates back towards the new long-run equilibrium level of e₃.

2.    “News”. A second factor that causes violent fluctuations in exchange rates is what may be called ‘news’. Exchange rates respond to news.

As exchange rates are closely related to expectations and to interest rates, the foreign exchange dealers have to keep an eye on all major news events affecting the economic environment. Since all the players in the foreign exchange markets are processionals, they are all well-informed about all the events taking place. They are equally well-informed about-forecasts of what is likely to happen in future.

Events that happen are of two types: (i) events that have been forecast beforehand, and (ii) events that are unforecastable.

(i)    Forecast and expected events are always reflected in the current exchange rate.
(ii)    A news about an forecast or unexpected event cause fluctuations in exchange rates.

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