Global Economic Analysis - Purchasing Power Parity and Interest Rate Parity

Purchasing Power Parity
Purchasing power parity expresses the idea that a bundle of goods in one country should cost the same in another country after exchange rates are taken into account. Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars in Canada than in the United States. We would then expect U.S. consumers to buy those goods in Canada. Even if this is not possible from a transportation or cost viewpoint, some businesses will have an incentive to buy the goods cheaply in Canada and remarket them in the United States. Such actions would cause U.S. dollars to be sold in exchange for Canadian dollars. As a result, the U.S. dollar would depreciate in relation to the Canadian dollar. We would expect the currency depreciation to continue until the bundle of goods costs the same in both countries.

Interest Rate Parity
Interest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks. However, exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be indifferent to either investment choice, as both are expected to earn 6%.

Why Central Banks Intervene in the Market
Suppose the United States Federal Reserve is interested in the dollar to euro exchange rate. It can directly influence that exchange rate by buying or selling euros with U.S. dollars. If the Fed buys euros with dollars, it will increase the supply of dollars and decrease the supply of euros. This action tends to cause the U.S. dollar to depreciate in relation to the euro.

A central bank will intervene in the foreign exchange market because it wishes to reduce volatility, and/or it has a specific target exchange rate. Suppose the Fed wants the euro and dollar to trade 1:1, with an allowable range of 2% in either direction. If the exchange rate rose to above 1.02 euros per dollar, the Fed would sell dollars; if the exchange rate fell below .98 euros per dollar, it would buy dollars.

Foreign Exchange


Related Articles
  1. Economics

    Macroeconomics: Currency

    By Stephen Simpson For citizens of different countries to conduct trade, they have to buy and sell each other's currencies. The price of a nation's currency, expressed as an amount of a second ...
  2. Investing Basics

    Understanding Risk Parity

    Risk parity is an investment strategy that focuses on the allocation of risk across a portfolio.
  3. Investing Basics

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  4. Forex Education

    Forex Tutorial: Economic Theories, Models, Feeds & Data

    There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the ...
  5. Forex Education

    4 Ways To Forecast Currency Changes

    Whether you are a business or a trader, having an exchange rate forecast to guide your decisions helps to minimize risks and maximize returns.
  6. Forex Fundamentals

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  7. Forex

    The Pros & Cons Of A Strong Dollar

    As the U.S. economy has emerged from the Great Recession, the strength of the U.S. dollar has also improved.
  8. Forex Education

    Top Economic Factors That Depreciate The $US

    A variety of factors contribute to currency depreciation, including monetary policy, inflation, demand for currency, economic growth and export prices.
  9. Savings

    U.S. Travelers: Book That Trip Abroad Now

    Appreciation of the U.S dollar against the euro and other currencies is making travel abroad cheaper. Here's how to benefit.
  10. Forex Education

    Profiting From A Weak U.S. Dollar

    Learn how to allocate your investments when the U.S. dollar is down.
RELATED TERMS
  1. Uncovered Interest Rate Parity ...

    A parity condition stating that the difference in interest rates ...
  2. Interest Rate Parity

    A theory in which the interest rate differential between two ...
  3. Risk Parity

    A portfolio allocation strategy based on targeting risk levels ...
  4. Law Of One Price

    The theory that the price of a given security, commodity or asset ...
  5. Conversion Rate

    The ratio at which one currency can be exchanged for another. ...
  6. Purchasing Power Parity - PPP

    An economic theory that estimates the amount of adjustment needed ...
RELATED FAQS
  1. Is risk parity a safe investment strategy?

    Learn how risk parity funds won't blow away the market, but will grow steadily over time by using the time-tested strategies ... Read Answer >>
  2. What are the nations with the highest PPP (purchasing power parity) with respect ...

    Learn which nations have the highest PPP with respect to the U.S. while reviewing the differences of calculating GDP in market ... Read Answer >>
  3. How does the balance of payments impact currency exchange rates?

    Take a brief look at the relationship between a nation's balance of payments and the exchange rate value of its currency ... Read Answer >>
  4. How can I get 100k in a Canadian bank to a U.S. Investment firm with minimal loss ...

  5. What do the terms weak dollar and strong dollar mean?

    The two terms, weak dollar and strong dollar, are generalizations used in the foreign exchange market to describe the relative ... Read Answer >>
  6. What economic indicators are most used when forecasting an exchange rate?

    Discover what economic indicators are most widely used to forecast a country’s exchange rate and how various factors influence ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center