Question

Based on purchasing power parity theory, should the Canadian Dollar, appreciate or depreciate? Please provide ample justification.

The currency of the country with a lower i rate should be at forward premium in terms of the currency of the country with a higher rate, so that the interest rate differential should be equal to the forward differential

That is the full question. No other information has been provided.

Answer 1

Here,

1 Canadian Dollar equals 0.76 United States Dollar

Its mean, Canadian dollar is cheaper than US dollar.

But the the theory of purchasing power parity  states that the exchange rate between one currency and another currency is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

It is not logical stating that having low PPP currencies will be depreciating and having high PPP currencies will be appreciating. Means, PPP does not affect exchange rates in the short term. However, it can impact inlong run economy.

Following example can make you understand how inlong run economy PPP can have impact in exchange rate.

In PPP "law of one price " does work here. The law of one price, states that arbitrage will force prices between two countries to equalize around a basket of goods and services, discounting transaction costs. For example, if you can exchange one U.S. dollar for one and a half Canadian dollars, then a TV priced at $500 in the U.S. should cost C$750 in Canada. If it cost only C$700, USA would purchase their TV’s in Canada. To do so, Americans would have to sell U.S. dollars and buy Canadian dollars, the effect of which would be to weaken the U.S. dollar and strengthen the Canadian dollar.

This example show how a strong currency can be depreciate. So, we can say there is no vital role of PPP in currency exchange rate.