Understanding corporate finance: foreign exchange: purchasing power parity
How exchange rates are determined: purchasing power parity
How do the markets determine at what particular spot rate a currency will trade, or what relationship a forward exchange rate should bear to the spot rate?
One hypothesis is ‘purchasing power parity’. For example, suppose that the same CD can be bought in the UK for £8 and in the USA for $12. It seems reasonable to believe that £8 should be equal in value to $12 (or £1 to $1.50). If the £/US $ exchange rate deviates from this level, consumers would rush to buy CDs in the cheaper country (perhaps over the internet), thus exerting pressure to return the exchange rate to its equilibrium level.
Experience tells us that purchasing power parity, at least in this simple form, rarely works. People and companies take factors other than relative prices into account when deciding where to buy goods and services. The costs, risks and feasibility of making the purchase in an overseas territory, indirect taxes such as VAT, and import duties all enter the equation.
In very general terms, however, it does tend to be case that countries with a high rate of inflation will have a depreciating currency.
Suppose, in the above example, the inflation rate in the UK is expected to be 5% in the next 12 months, while the inflation rate in the USA is expected to be 2%. The price of the CD in the UK can be expected to rise to £8.40 (£8 x 105%). In the USA, the CD might cost $12.24 in year’s time ($12 x 102%). The exchange rate to be expected in a year’s time would be £8.40 = $12.24, or $1.4571/£. In other words, sterling - the currency of the country with the higher inflation rate - has depreciated against the dollar.