Question

Explain why, in order to preserve the purchasing power parity (PPP), a country with a higher inflation should have its currency depreciate against currencies of countries with lower inflation, all else equal (including real rates of interest in different countries).

3 sentences

Answer 1

For maintaining the purchasing power parity if inflation of domestic country increases then the exchange rate of domestic currency decreases with respect to foreign currency by the formula. Exchange rate D/F currency after inflation = Spot Exchange rate * (1+ Inflation of domestic currency)/(1+ inflation of foreign currency). So to maintain same PPP the currency needs to devalue using above formula because with inflation money supply increases and with currency depreciation value of goods increases, hence the citizens can purchase the same amount of goods as increase in inflation is offset by depreciation of currency

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