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:
S1 / S0 = (1 + Iy) ÷ (1 + Ix)
S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.
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.
Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the
So the relevant equation is:
S0.5 ÷ S0 = (( 1 + Ius) ÷ (1 + Ieurozone))0.5
= S0.5 ÷ $1.20 per euro = (1.02 ÷ 1.08)0.5
Which implies S0.5 = (1.20) × 0.978125 = 1.1662
So the expected spot exchange rate at the end of six months would be $1.1662 per euro.
Assume that the
S0 = 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: (Iy - Ix) =(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:
S1 = (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.
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.
MarketsBy 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 ...
TradingLearn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
TradingAn in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
InvestingInterest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
MarketsA real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors.
TradingThe exchange rate is one of the most important determinants of a country's relative level of economic health, and can impact your returns.
MarketsPurchasing 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 ...
MarketsThe Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
TradingIn general, higher interest rates in one country tend to increase the value of its currency.
TradingUncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.