Question

The inflation rates in the British pound and the Australian dollar are 2% and 8% respectively. What should the Sex /Forward ER be, if the Spot ER is BP/ A$ .1? Describe the concept of purchasing power.

Answer 1

According to theory of Purchase Power Parity ,if I_n and i_f are the inflation rates in home currency and foreign currency respectively; and ER₀ is the value in terms of home currency for one unit of foreign currency at the beginning of the period (spot rate) and ER₁ is the value in terms of home currency at the end of the period (forward rate) , then ER₁/ER₀ = 1+i_n/1+i_f

ER₁/0.10= 1+0.08/1+0.02

ER₁= 0.10*1.08/1.02= 0.10588235

Purchasing Power

Purchasing Power of a currency is determined by the amount of goods and services that   can   be purchased with one unit of that currency. If there is more than one   currency   , it is fair and equitable that exchange rate between these currencies provides the same purchasing power for each currency(purchasing power parity) . Purchasing Power is important because   , all else being equal   , inflation decreases the amount of goods and services you would be able to purchase.

Let us assume that cost of one Barrel of Crude Oil in 1990 was $23, today we have to pay   $74 for one barrel of crude oil. This is an example of change in Purchasing Power of an American Dollar. This decrease in purchasing power is called inflation. There are two reasons for   this decreasing purchase power . 1 Demand for petrol increases (Demand – Pull Theory) 2. Companies rise places to cover manufacturing cost and maintain profits, inflation is created (Cost-Push Theory)

Consumer price index is a measure of purchasing power, which measures change in retail price of goods and services.