Inflation & PPP

Inflation is apart of every countries economic structure, and is the rate at which the general level of prices for goods and services rise each year. It is why many goods generally will increase in price over time. It’s the reason why our parents go on about how little things used to cost when they were little.

Inflation is represented by a percentage, and in most cases a countries central bank tries to maintain the rate at around 2-3% per year. The central bank which does this in Australia is the Reserve Bank of Australia. The simplest example to highlight the affects of inflation is to say for example in Australia this year inflation is expected to rise by 2%. Because of this rise, say a bottle of milk that last year cost $1.00 is now priced at $1.02 because of the inflation rate rise.

Like interest rates, inflation also plays a big part in the way exchange rates are determined. Because each country will have a different inflation rate, the exchange rate between the 2 over time, will automatically adjust to compensate for the difference.

Example

Say the current spot rate is:

USD 0.7500 AUD

Meaning $1 Australian Dollar equals 75 US cents. Now say that the inflation in the US is greater than that in Australia. For example inflation is 5% in the US and 3% in Australia. This would mean that in Australia you would be getting more value for your money, as goods and services are only 3% more than what you would be expecting to pay from last year, whereas in America they have increased 5% – a 2% difference in inflation rates.

Because of this inequality, the exchange rate will adjust to compensate for the inflation rates not being equal. Because American goods are relatively more expensive, American will converting their USD to get AUD so that they can buy goods in Australia. The increases in the supply of USD and the demand for AUD will drive up the price of AUD.  USD will continue to depreciate until an equilibrium point is reached. Or put simply, if the above example of inflation rates holds true, then $1 Australian dollar would now be able to purchase more US dollars than before. This means that the Australian dollar has increased in value, while the US dollar has fallen.

The mechanics behind this theory have been developed from something called Purchasing Power Parity or PPP in short hand. Purchasing Power Parity simply means that no matter which country you are in, it would cost the same to buy an item in that country as it would in any other country you are in. However as we all know this is not true. The easiest example is when Australians or tourists from more developed countries go to Asian countries and find many bargains. Goods in Asia are so much cheaper than that of their own country generally speaking. PPP simply states that the exchange rate between two currencies will adjust to reflect the relative inflation rates in the two countries.  It is assumed that the law of one price is valid.