Question

Describe the relation between inflation differences between countries and depreciation of foreign exchange rate (against the reference country currency) by referring to Purchasing Power Parity (PPP) ?

Answer 1

The purchasing power theory describes how countries maintain an equilibrium exchange rate. At equilibrium, the purchasing power of both currencies should be equal. Now if one country is facing higher inflation than the other, its goods will become less competitive in the international markets. In order to restore competitiveness, the currency of this country must depreciate as compared to the other country. Thus, if inflation in one country is higher, the value of the currency of that country will fall (depreciation) relative to the other country's currency.