INTERNATIONAL TRADE pointed out that international trade tends to equalize prices across the world because it equalizes the costs of the factors of production. Thus, as long as there is free trade, exchange rates should adjust so that the same product costs the same number of monetary units worldwide, except for differences in transportation costs and other added charges. This principle is the basis for the oldest and still the most accurate exchange rate determination theory, the Purchasing Power Parity (PPP) Theory, illustrated in part a of Figure 8.1.
The Purchasing Power Parity Theory holds that the exchange rate between any two national currencies adjusts to reflect differences in the price levels in the two countries. If, for example, an American car costs $10,000 and an equivalent German car costs 20,000 deutsche marks (DM), what must be the exchange rate between the dollar and the DM? Since 20,000 DM must be the equivalent of $10,000, each DM must be worth 50 cents (10,000/20,000 = 0.50). Why is that so?
To find the answer, we must figure out what would happen if the exchange rate were more or less than that dictated by the PPP theory. Suppose that one DM were worth 60 cents. Then a German car would cost $12,000 in the United States (20,000 X 0.60), while the American car would still cost American buyers $10,000. This price difference of $2,000 would be enough to cause not only all Americans but also most foreigners, including Germans themselves, to come to the United States to buy American cars.
The result of these developments would be an adjustment in the exchange rate between the two countries. The DM would depreciate (one DM would buy fewer dollars ), or the dollar would appreciate ( one dollar would buy more DM). If the market mechanism failed to adjust the exchange rates, the government of one of the countries would do so. Germany would, for example, devalue its DM (decrease the official value of its currency), or the United States would revalue its dollar (increase the official value of its currency).
Indirectly, the PPP theory is a good predictor of the effects of a persistent increase in prices in one country (inflation) on exchange rates. Suppose that over a five-year period prices in the United States rose 33% , while in Germany they rose 60% . The PPP theory predicts that the DM would depreciate relative to the dollar (that is, one DM would buy fewer dollars). Further, the PPP theory predicts the amount of the currency depreciation (that is, how many fewer dollars a DM would buy or how many more DM a dollar would buy). Figure 8.2 shows the predicted effects of changes in prices on exchange rates in the two countries.
In general, the PPP theory states that differences in national inflation rates are the major cause of adjustments in exchange rates. Countries with faster inflation rates experience more frequent depreciations and devaluations than do countries with slower inflation rates. Though one can cite many exceptions to the above rule (primarily with respect to the relationship of the United States dollar to the currencies of Western Europe and Japan during the early 1980s), most economists believe that in the long run the PPP theory explains exchange rate determination rather well.
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