Forex: The Purchasing Power Parity Theory

To explore further the relationship between money supplies and exchange rates, and to see more clearly the possible long-run combinations of currency depreciation and price inflation rates that are possible, a turn to a long-standing hypothesis relating price levels and exchange rates.

Assuming now that the different countries are not on the gold standard and that they can follow independent domestic credit policies, how can international payments be brought into equilibrium and how will the exchange rates be determined? The answer seems obvious.

If country A has inflated its currency and if its general price level has risen in comparison with the price level in country B, people in country B will not be willing to pay the same price for A's currency as before. At a correspondingly lower price they will trade with A since their increased price level has been neutralized for them through the lower price for A's money.

Now, if A's and B's currencies used to exchange at a ratio of 5:1 and if, at the end of an inflation period, prices in country A have risen four times their original level while B's prices are only twice as high as before; the new exchange rate should be approximately 10:1. In general, it may be said that changes in the foreign exchange rate are determined by, and are in proportion to, the changes in the relative domestic purchasing powers of the currencies in question as expressed by the respective price levels.

This is the so-called purchasing power parity theory. After a period of inflations and deflations, the purchasing power parity theory may serve as a useful reminder that pre-inflation or pre-deflation parities can no longer be used and that the new exchange rates must be found in the neighborhood of the new purchasing power parities.

Unfortunately it is impossible to calculate reliable exchange rates on the basis of relative changes in price levels as expressed by index numbers. If we take an average level of domestic prices--- prices of goods which are not internationally traded, we cannot assume that changes in these prices will directly affect international trade and therefore, the rate of exchange.

On the other hand, if we take internationally traded goods the purchasing power parity theory becomes an empty truism since world market prices are translated into domestic terms by means of the exchange rates. There are furthermore, many instances where the rate of exchange may be fluctuating, while the price levels in the different countries remain the same.

This theory argues that the exchange rate between two currencies has to follow. Further, this theory is beset by some major problems, but it has been shown to be roughly correct in which country is experiencing hyperinflation.