Purchasing Power Parity Theory
According to the theory of purchasing power parity (PPP theory), the exchange rates of a nation remain at equilibrium when the purchasing power of the two nations is similar. High inflation rate in the United States currency makes the dollar to depreciate, while the currency of the other nation appreciates. Consequently, the cost of products increases, and the rates of exchange rate become too high to be in equilibrium. This results in inequality, which affects the importation and exportation behaviours, thus impacting the depreciation of the dollar.
It is worth noting that the alterations in the exchange rates are caused by variations in the relative prices of the two nations. The assumption is that products are always retaining fixed costs in the market basket. PPP theory postulates that exchange rate adjusts completely to offset the defects of different rates in two countries (Thomas, 2006). When changes reflect inflation of rates, the differential inflation rates trigger fluctuations in the exchange rates in line with PPP theory. Inflation lowers the quantities of good consumers who are able to purchase.
If the United States is trading with a less developed country, its demand for exports makes its currency to appreciate in value. On the other hand, the currency of the importing nation will depreciate. When evaluated in the short run, correlation between the price movements and the exchange rate movements in the United States and the other nation it is trading with does not exist.
Carbaugh (2009) states that a currency will be expected to depreciate by an amount equal to the excess of domestic inflation over foreign inflation. It would appreciate by an amount equal to the excess of foreign inflation and domestic inflation. For favourable trade between the United States and a country whose inflation did not change, the dollar should depreciate at a rate similar to that of its inflation.
Carbaugh, R. J. (2009). International economics. Mason, Ohio: South-Western Cengage Learning.
Thomas, L. B. (2006). Money, banking, and financial markets. Mason (OH: South