Understanding the Link Between Exchange Rates and Inflation

Ever wondered why the value of 1 American dollar is different from 1 Euro? The economic theory of purchasing power parity (PPP) will help you understand why different currencies have different purchasing powers and how exchange rates are set.

The Dictionary of Economics defines purchasing power parity (PPP) as a theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

Example of 1 for 1 Exchange Rate

How does inflation in 2 countries affect the exchange rates between the 2 countries? Using this definition of purchasing power parity, we can show the link between inflation and exchange rates. To illustrate the link, let's imagine 2 fictional countries: Mikeland and Coffeeville.

Suppose that on January 1st, 2004, the prices for every good in each country is identical. Thus, a football that costs 20 Mikeland Dollars in Mikeland costs 20 Coffeeville Pesos in Coffeeville. If purchasing power parity holds, then 1 Mikeland Dollar must be worth 1 Coffeeville Peso. Otherwise, there is the chance of making a risk-free profit by buying footballs in one market and selling in the other. So here PPP requires a 1 for 1 exchange rate.

Example of Different Exchange Rates

Now let's suppose Coffeyville has a 50% inflation rate whereas Mikeland has no inflation whatsoever. If the inflation in Coffeeville impacts every good equally, then the price of footballs in Coffeeville will be 30 Coffeeville Pesos on January 1, 2005. Since there is zero inflation in Mikeland, the price of footballs will still be 20 Mikeland Dollars on Jan 1, 2005.

If purchasing power parity holds and one cannot make money from buying footballs in one country and selling them in the other, then 30 Coffeeville Pesos must now be worth 20 Mikeland Dollars. If 30 Pesos = 20 Dollars, then 1.5 Pesos must equal 1 Dollar.

Thus the Peso-to-Dollar exchange rate is 1.5, meaning that it costs 1.5 Coffeeville Pesos to purchase 1 Mikeland Dollar on foreign exchange markets.

Rates of Inflation and Currency Value

If 2 countries have different rates of inflation, then the relative prices of goods in the 2 countries, such as footballs, will change. The relative price of goods is linked to the exchange rate through the theory of purchasing power parity. As illustrated, PPP tells us that if a country has a relatively high inflation rate, then the value of its currency should decline.