If you travel to a foreign country, whether it is for business or pleasure, you convert your dollars to the local currency. Depending on where you visit and what you buy, you may find your trip to be a bargain or an expensive sojourn. One theory that helps explain how exchange rates are determined is purchasing power parity.
Purchasing Power Parity
Since the 1970s, exchange rates have been primarily determined by supply and demand, with occasional government intervention to stabilize exchange markets. One theory that describes how rates reach specific levels is purchasing power parity. According to this theory, you should be able to exchange your currency from one country to another and be able to buy the same goods in each country. In other words, the exchange rate will give you the same spending power in every country you visit.
The Big Mac Index
Taking the principle of purchasing power parity to a whimsical level, the Economist magazine has developed the Big Mac Index, measuring the price of Big Macs in 100 countries and converting each price to U.S. dollars. Tongue in cheek, the Economist compares each country's Big Mac price to the U.S. price. They should be equal, but if they are not, then the foreign currency is either overvalued or undervalued. Of course, the Big Mac Index is a fun exercise, but it does illustrate in a very simple manner the principle of purchasing power parity.
Purchasing Power Parity in Action
Suppose that a market basket of goods costs $1000 in the United States and 600 pounds in Great Britain. Following the purchasing power parity theory, the exchange rate should be $1.00 = 0.6 pounds. If the exchange rate were different, say $1.00 = 1 pound, then you could convert $1000 to 1000 pounds, buy the market basket for 600 pounds and have 400 pounds left over. The pound would then appreciate in value -- the dollar would lose value and "buy" fewer pounds -- until the equality in purchasing power had been restored.
What Determines Exchange Rates
While purchasing power parity is certainly the major factor in determining long-term exchange rates, it is not the only consideration in the short-run. Differing rates of inflation between countries will cause the purchasing power of each currency to change, impacting the exchange rates. Changes in tastes will have an effect on exchange rates. A change in demand for imported automobiles, for example, will cause an increase in the demand for foreign currency as importers need to pay for their imports. If one country is growing faster than another, the growing country's demand for imports will cause its currency to depreciate in value, while the exporter's currency appreciates. While these are all relatively short-term adjustments, the underlying principle of purchasing power parity holds in the long-run.
- Photodisc/Photodisc/Getty Images