Question

Explain the purchasing power parity theory of exchange rates, using the euro-dollar exchange rate as an example.

Answer 1

Solution-

Is a theory, which states that exchange rates between currencies are in equilibrium when their purchasing power of the same good is the same in each of the two countries.(MacEachern, A.) The reason for the purchasing power parity theory is because we must adjust values of currencies to give them their proper worth in comparison of each other. How we do this is with the formula below. "S" represents exchange rate of currency1 to currency 2"P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2 (2016)

E = P / Pf

E represents the spot exchange rate

P is the domestic price index

Pf is the foreign price index

Therefore, if something is the United States cost 5,000 US dollars and the same good cost 2,500 Euros in Europe then their exchange rate would be 2:1.

In order to hold the purchasing power parity if either currency were to fluctuate due to various reasons like inflation or other monetary acts the ratio would have to change to account for the currencies value change.