Purchasing Power Parity Theory: 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. In short, what this means is that a bundle of goods should cost the same in two countries once the exchange rate is taken into account. Using this definition, the link between inflation and exchange rates can be shown. To illustrate the link, two fictional countries: Mikeland and Coffeeville are taken into account. If on January 1st, 2012, 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 Coffeville Peso, otherwise a risk free profit can be made by buying footballs in one market and selling in the other. So here PPP requires a 1 for 1 exchange rate. Now let's suppose Coffeville 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 Coffeville 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 Coffeville Pesos to purchase 1 Mikeland Dollar on foreign exchange markets. If two countries have differing rates of inflation, then the relative prices of goods in the two 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 we have seen, PPP tells us that if a country has a relatively high inflation rate we should see the value of its currency decline.

Effect of Inflation on exchange rate:

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

1. The rate of inflation. The ratio of currency in their purchasing power (purchasing power parity) serves as a kind of axis of the exchange rate reflecting the law of value. That's why the rate of inflation has an impact on the exchange rate. All other things being equal, the inflation rate in the country has inversely proportional impact on the value of national currency, i.e. an increase in inflation in the country leads to a reduction in the national currency, and vice versa. Inflationary depreciation of money in the country reduces the purchasing power and a tendency to a drop in their currency's exchange rate against currencies of countries where the rate of inflation is lower. Alignment of the exchange rate and adjustment to purchasing power parity are occurred within two years. This is because the daily quotation of exchange rates is not corrected on the basis of their purchasing power, and there are other factors of forming of exchange rate.

If we define inflation as an increase in the price of goods and or an increase in the price of living as measured in the currency of the country in question then an increasing inflation rate will be seen as an apparent decrease in the value of the currency. Assuming that other countries experience LESS price increase then the value of the subject country's currency will fall relative to the other currencies. As prices increase so do percentage markups such as profits and dividends which in this way increase automatically in line with increasing prices. The higher prices are felt by wage and salary earners who demand increases in line with increasing prices, in line with the increasing cost of living. Prices increase as a result, the increase depending both on the extent to which wage and salary demands are satisfied and on how much of the price consists of labour costs.