purchasing-power parity theory

purchasing-power parity theory

a theory of EXCHANGE-RATE determination that postulates that under a FLOATING EXCHANGE-RATE SYSTEM, exchange rates adjust to offset differential rates of INFLATION between countries that are trade partners in such a way as to restore BALANCE OF PAYMENTS EQUILIBRIUM. Differential rates of inflation can bring about exchange-rate changes in two principal ways. The first relates to the effect of changes of relative price on import and export demand. As the price of country A's products rise relative to those of country B, demanders of these products tend to substitute away from A and towards B, decreasing the demand for A's currency and increasing the demand for B's currency This leads to a DEPRECIATION of the bilateral exchange rate of currency A for currency B. Thus, a higher level of domestic prices in country A is ‘offset’ by a fall in the external value of its currency

A second way that exchange rates can change in response to differential rates of inflation is through SPECULATION about future exchange-rate movements. As prices rise in country A relative to country B, managers of foreign-currency portfolios and speculators anticipate an eventual lowering of the real value of the currency in terms of its purchasing power over tradeable products and tend to substitute away from it in their holdings, again causing a depreciation of currency A.

This theory therefore predicts that differential rates of inflation lead to compensating exchange-rate changes. It is also possible, however, that exchange-rate changes themselves can lead to differential rates of inflation; if, for example, import demand is highly price-inelastic, an exchange-rate depreciation may lead to an increase in domestic inflation. There is thus a problem in respect of causality (see DEPRECIATION). See also ASSET-VALUE THEORY.

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