Examine how the purchasing-power parity theory determines exchange rates and their implications on trade, job creation and interest rate on the country.
Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach. According to this concept, two currencies are in equilibrium or at par when a market basket of goods (taking into account the exchange rate) is priced the same in both countries. To make a comparison of prices across countries that holds any type of meaning, a wide range of goods and services must be considered. The amount of data that must be collected, and the complexity of drawing comparisons makes this process difficult. These actions often impact financial markets in the short run. Using PPPs is the alternative to using market exchange rates. The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. PPP is determined in each country based on its relative cost of living and inflation rates. Purchasing power plus parity ultimately means equalizing the purchasing power of two differing currencies by accounting for differences in inflation rates and cost of living. As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency. Adam Smith used an hour's labour as the purchasing power unit, so value would be measured in hours of labour required to produce a given quantity (or to produce some other good worth an amount sufficient to purchase the same). Interest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks. However, exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be indifferent to either investment choice, as both are expected to earn 6%. Sources: http://www.investopedia.com