Purchasing Power Parity Theory
Foreign exchange rates are dependent on inflation. Higher the inflation rate in one country as compared to the other country results in discount of currency of that country and vice-versa.
Example
On 01/01/2020
1 Euro = 1.4000 $
And 1 Kg. of goods ' X ' can be purchased in
USA for 1.0000 $
Europe for 0.8772 Euro.
It means 1 Kg. of goods ' X ' can be me purchased by 1.0000 $ in either USA or in Europe.
Or
1 Kg. of goods ' X ' can be purchased by 0.8772 Euro in either USA or in Europe.
Suppose, Inflation rate in Europe is 2% and 3% in USA.
After one year ( on 31/12/2020 )
1 Kg. of goods can be purchased by
In USA 1.0000 X 1.03 = 1.0300 $
In Europe 0.8772 X 1.02 = 0.8947 Euro
According to Purchasing Power Parity Theory, purchasing power should be same in both countries.
Therefore,
Price of 1 Kg. of goods ' X ' = 1.0300 $ = 0.8947 Euro
=> 1.0300 $ = 0.8947 Euro
=> 1.000 Euro = 1.1512 $
In the given example inflation rate in USA is higher than Europe.Therefore '$' depreciate against ' Euro.
Thank you for reading.