FREE online courses on Investment Decisions in Exchange Rates - Relative Purchasing Power Parity

 

The Relative version of the Purchasing Power Parity theorem states that changes in the exchange rate between two currencies are determined by changes in the relative prices in the two countries in question.  In other words,

 

 

                   =     .

 

 

If we let the ratio P/Prepresent the expected rate of inflation, I$ , then the expected exchange rate can be expressed as

 

          E(S)     =     S.

 

For example, assume that the exchange rate between the dollar and the French franc is currently $0.1600/FF1.  Then if inflation in the U.S. is expected to be 3 percent per year and inflation in France is expected to be 5 percent per year, the exchange rate between the dollar and the French franc in one year should be

 

                   $0.1570/FF 1     =     $0.1600/FF1  .

 

The Relative Purchasing Power Parity relation can be generalized to predict exchange rates N periods in the future (assuming of course that we have forecasts of inflation in the respective countries over the time period covered by the exchange rate in question).  This general relation is given by

 

                                                E( S)    =    S[ ]N

 

 

For example, assuming that inflation in the U.S. and France are respectively expected to run at 3 percent and 5 percent per year over the next two years, the exchange rate between the dollar and the French Franc in two years should be

 

                   $0.1540/FF1     =     $0.1600/FF1  .

 

Intuitively, if a country experiences higher inflation than its trading partners, then its exports become less competitive overseas and foreign imports become more competitive at home.  The resulting deficit in the balance of trade puts downward pressure on the exchange rate.