When a company is dealing with foreign currency, it is important to know the exchange rate and how it fluctuates. This is important for companies to keep up with the countries that they have monetary ties with. Many don’t think about the determents of the foreign exchange rates and what contributes to the rising and falling. It isn’t something easy to explain. There are three major schools of thought with each having individual drivers within that drive each approach. The three main approaches are the Purchasing Power Parity (PPP) approach, the Asset Market approach and the Balance of Payment (BOP) approach. These do not compete against each other, but complement each other. Some prefer one over the other or may even use a combination of them. This paper will briefly discuss each approach and how they relate to each other, while hopefully giving you some insight on which might be the best fit for your uses within your business.
Purchasing Power is the value of a currency expressed in terms of the amount of goods or services money can buy. Purchasing power is important because, if all else being equal, inflation decreases the amount of goods or services you'd be able to purchase. In order to measure purchasing power, you would have to compare against price index. An easy way to understand what purchasing power is to imagine if you made the same salary as your grandfather made and if you could survive on that. Obviously you could survive on much less than a few generations ago, however, because of inflation; you'd need a greater salary just to maintain the same quality of living. Many people can survive on a lower salary, but quality of living plays a big part as well.
The purchasing power parity (PPP) is a theory that states that a price of an internationally traded commodity should be the same in every country; therefore the exchange rate between the two should also be the ratio of prices in the two countries (www.investopedia.com). In other words, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency.
One the most found ways to explain what PPP is by using the Big Mac Index. A survey was done by the Economist that showed what a country's exchange rate would have to be for a Big Mac in that country to cost the same as it does in the United States. With the Big Mac Index purchasing power is reflected by the price of a McDonald's Big Mac in a particular country. This measure gives an impression of how overvalued or undervalued a countries currency is. The Big Mac is driven based on various markets, so you can see how flawed the Big Mac Index can be as prices of Big Macs may not even remain constant within nations or within our country. Therefore, the comparison of the Big Mac Index is apples to oranges on products where prices may never level and parity may never be achieved. This is considered the absolute PPP.
Relative PPP states that PPP is not...