What Is Purchasing Power Parity And Exchange Rates?

In the short run market determined exchange rates are highly volatile in response to monetary policy, political events and changes in expectations. But over the long run economists believe exchange rates are determined primarily by the relative prices of goods in different countries. An important implication is the purchasing power parity theory of exchange rates. Under this theory a nation's exchange rate will tend to equalize the cost of buying traded goods at home with the cost of buying those goods abroad.

A special case is the law of one price, which states that identical goods must sell at the same price in all markets. The purchasing power parity theory can then be illustrated with a simple example. Suppose the price of a market basket of goods costs $1000 in the United States and 10,000 pesos in Mexico. At an exchange rate of 100 pesos to a dollar, this bundle would cost $100 in Mexico.

Given these relative prices and the free trade between the two countries, we would except to see American firms and consumers streaming across the border to buy at lower Mexican prices. The result will be higher imports from Mexico, and an increased demand for Mexican pesos. That will cause the exchange rate of the Mexican peso to appreciate relative to the U.S dollar, so you will need more dollars to buy the same number of pesos.