There are several theories behind the determination of foreign exchange rates. One of them is the Purchasing Power Parity (PPP) approach.
According to this theory the price of a good that is charged in one country should be equal to the one charged for the same good in another country, being exchanged at the current rate. This rule is also known as the law of one price. Two versions of the purchasing power parity theory have been developed:
Absolute Version of Purchasing Power Parity Theory
Under the conditions of this version the exchange rate at which the identical goods are measured is equal to the ratio of the price levels of the two countries. The price levels reflect the weighted average of all goods that have been produced in a particular country.
The absolute PPP approach could be expressed with the following formula:
p = p* / e
In this formula p represents the domestic prices, p* represents the foreign prices and e represents the exchange rate.
However, there are some drawbacks of this version of the PPP theory which could make it not hold. Here are some of them:
- identical production and consumptionThis version of the PPP theory will only work when two countries that produce and consume the same goods can be found, which is relatively impossible in reality.
- transportation costs and trade restrictionsThe assumption that there are insignificant transportation costs, trade restrictions and differential taxes applied between two markets is hardly a good one. In the real world transport costs and trade barriers do exist, greatly differ from one country to another and have a great influence on the price level of a particular good.
- non-tradable goodsMany identical items sell for different prices because they have non-tradable inputs in their production process. This implies that the same product may have different prices in different locations because of the production cost differentials of those locations.
- brand namesThe importance of brand names is not taken under consideration under this version. Some products’ demand is dependent on the brand name of the producer.
Relative Version of Purchasing Power Parity Theory
The relative PPP version states that the difference between the percentage change in the domestic price level and the percentage change in the foreign price level should give the percentage change in the exchange rate from a given base period.
The relative PPP theory takes into account inflation rate differentials and could be expressed with the following formula:
1 + π = (1 + π*) (1 + ê)
In this formula π represents domestic inflation, π* represents foreign inflation and ê represents depreciation.
Like the absolute Purchasing Power Parity version, the relative has its drawbacks.
- It is difficult to determine the base period.
- Trade restrictions are underestimated by this PPP version too.
- There are also long-term comparison problems because the price index weighting is different and different products are included in the indexes.
- The exchange rate may diverge from the relative PPP under the influence of a change in the internal price ratios.
Finally, relative domestic and foreign prices experience a different movement as compared to spot exchange rates. The commodity market conditions have no effect on the exchange rates over the short term. However, financial market conditions play a major role on the movement of exchange rates.