Question

What is the link between purchasing power parity, inflation and the exchange rate

Answer 1

Ans.

RELATIVE PURCHASING POWER PARITY

Relative purchasing power parity is a theory that relates the change in two countrie's expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency because the prices of goods and services go high. If a country has an annual inflation rate of 10%, then country's purchasing power will be reduced and people will ne able to purchase 10% less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.

Formula For Relative Purchasing Power Parity

S₁ / S₀ = (1 + I_y) ÷ (1 + I_x)

Where,
S₀ is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)
S₁ is the spot exchange rate at the end of the time period.
I_y is the expected annualized inflation rate for country y, which is considered to be the foreign country.
I_x is the expected annualized inflation rate for country x, which is considered to be the domestic country.

EXAMPLE
Suppose that Mexico's expected annual rate of inflation is equal to 6% per year, while the expected annual inflation rate for the U.S. is 3%. As an approximation, we would expect that the Mexican peso would depreciate at the rate of 3% per year (or we could say that the U.S. dollar should appreciate at the rate of 3% per year.