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. Investing

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  2. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  3. Investing

    Explaining Interest Rate Parity

    Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
  4. Investing

    Understanding Risk Parity

    Risk parity is an investment strategy that focuses on the allocation of risk across a portfolio.
  5. Insights

    Purchasing Power Parity (PPP)

    Purchasing Power Parity (PPP) compares different countries' currencies through a market "basket of goods" approach. Two currencies are in PPP when a market basket of goods (taking into account ...
  6. Insights

    What Is Purchasing Power Parity? (PPP)

    Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach.
  7. Trading

    Here's How You Calculate An Exchange Rate

    Struggling to get a grasp on exchange rates? Here's what you need to know.
  8. Investing

    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.
  9. Investing

    How To Calculate An Exchange Rate

    An exchange rate is how much it costs to exchange one currency for another.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center