How Foreign Exchange (FOREX) Rates Are Determined

Purchasing power parity (ppp) states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate-the law of one price.

There are two version of ppp, the absolute and the relative version.

Lets look at the absolute version first. This version stipulates the exchange rate should be equal to the ratio of the price level of goods within two different countries. A weighed average of all the goods produced in each country will give us these price levels.

Immediately we see a flaw with this theory; the two countries would need to consume the same goods. Brands do not matter under this theory, and yet we know that different brands cost different amounts. As a simple example, if cars are the basis for our exchange rate, we may have equal amounts of cars, which would make the currencies equal. But if one country drives only new BMWs and the other country drives only 1980 Lebarons, we can see that one country is worth less than the other (no disrespect to the Lebaron). Of course this is a very simplified example. The currencies should not be equal, as the theory would imply. Countries must consume and produce similar goods in order for this absolute version of the ppp to hold. It should also be noted that the absolute model does not take costs such as transportation or trade barriers into account. These are significant, and should be factored.

The other version of ppp, is the relative version which can be defined as "the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level."

This is a rather wordy definition but basically it means that changes in price levels in one country must also be reflected in the other countries price levels. With this theory we also run into problems. We run into the same problem as with the absolute model - how do we define the price levels? Goods must be identical in order for this theory to really work. Also, the "base period" chosen is somewhat of an arbitrary number.

So while the purchasing power parity sounds nice and neat in theory, it can be concluded that this fundamentalist theory does not determine foreign exchange rates. Domestic and foreign prices are not dependent on each others relative movements, and therefore neither are spot exchange rates.