Global Economic Analysis  Relative Purchasing Power Parity
Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency. If a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.
The relationship can be expressed as follows, using indirect quotes:
Formula 5.6
S_{1} / S_{0} = (1 + I_{y}) ÷ (1 + I_{x})
Where,
S_{0} is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)
S_{1} is the spot exchange rate at the end of the time period.
I_{y} is the expected annualized inflation rate for country y, which is considered to be the foreign country.
I_{x} is the expected annualized inflation rate for country x, which is considered to be the domestic country.
Look Out! Note that the spot exchange rate used must be the quantity of currency y (the foreign currency) needed to purchase one unit of currency x (the domestic currency). If we want the spot value of the U.S. dollar in British pounds, the quote must be 0.6667 British pounds per dollar, not $1.50 per British pound. 
Example 1:
Suppose that
Example 2:
Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the
Answer:
So the relevant equation is:
S_{0.5 }÷ S_{0} = (( 1 + I_{us}) ÷ (1 + I_{eurozone}))^{0.5}
= S_{0.5} ÷ $1.20 per euro = (1.02 ÷ 1.08)^{0.5}
Which implies S_{0.5} = (1.20) × 0.978125 = 1.1662
So the expected spot exchange rate at the end of six months would be $1.1662 per euro.
Example 3:
Assume that the
Answer:
Because
S_{0} = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.
The approximation method would indicate that the yen should decline against the dollar by: (I_{y}  I_{x}) =(1.0489  1.0623) = 0.0134 = 1.34%
So the value of the yen relative to the dollar would be expected to decline to
(1  0.0134) × 115 = ¥113.46 per $
We can calculate the rate more exactly as:
S_{1} = (1.0489) / (1.0623) × 115 = ¥113.55 per $
Purchasing Power Parity and Real Return on Assets
The purchasing power parity principle also applies to the real returns on assets earned by various investors across the world. It holds that the real rate of return on assets should be the same for investors from any nation.
Suppose that a financial asset from
By the approximation method,
Note that purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.
Exam Tip!
Past exams have included questions that require purchasing power parity calculations, so it is a good idea to practice solving questions such as the examples given above. 

Professionals
Purchasing Power Parity and Interest Rate Parity
CFA Level 1  Purchasing Power Parity and Interest Rate Parity. Examines the interest rate and purchasing power parities between countries. Explains why the central banks intervene in the currency ... 
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 ... 
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. 
Professionals
Interest Applications
CFA Level 1  Interest Applications. This section provides proof for the interest rate parity between currencies. It gives formulas and sample calculations behind the parity. 
Professionals
Absolute and Relative Purchasing Power Parity
CFA Level 1  Absolute and Relative Purchasing Power Parity. Discusses the absolute purchasing power parity, providing sample calculations and the formula behind the theory. 
Term
What's a Real Rate of Return?
A real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors. 
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 daytoday trading, it is helpful to understand the overarching ideas behind the ... 
Investing Basics
Explaining Interest Rate Parity
Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets. 
Forex
Main Factors That Influence Exchange Rates
The exchange rate is one of the most important determinants of a country's relative level of economic health, and can impact your returns. 
Forex
Economic Theories
Economic indicators can have a huge impact on the market. Getting to know them is essential for forex traders.

Interest Rate Parity
A theory in which the interest rate differential between two ... 
Uncovered Interest Rate Parity ...
A parity condition stating that the difference in interest rates ... 
Real Interest Rate
An interest rate that has been adjusted to remove the effects ... 
Relative Purchase Power Parity
An expansion of the purchase power parity theory, which suggests ... 
Nominal Interest Rate
The interest rate before taking inflation into account. The equation ... 
Purchasing Power
The value of a currency expressed in terms of the amount of goods ...

How does inflation affect the exchange rate between two nations?
Understand how inflation can affect foreign exchange rates of a currency and how it is just one of many economic factors ... Read Answer >> 
A U.S. investor purchased some shares in Germany for 25 euros and sold them a year ...
Free info on financial certification exams including study guides, exam questions, and much more! Read Answer >> 
How do changes in national interest rates affect a currency's value and exchange ...
Understand the role that changes in interest rates can play in determining the value and foreign exchange rate of a country's ... Read Answer >> 
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 >> 
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 >> 
What is the difference between real and nominal interest rates?
Learn what nominal interest rates and real interest rates are, how real interest rate takes into account the inflation rate, ... Read Answer >>