Reference no: EM131306539

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PPP theory states that the exchange rate between countries is at equilibrium (Washington 2012). This means the US dollar value will have its full worth in other countries. The exchange rate is affected by the market prices and vice versa (Washington 2012). As discussed in the Big Mac Index (Washington 2012), inflation will eventually happen disrupting the equilibrium and the exchange rate can downward affect on domestic prices. This will also affect living standards and buying patterns.

As long as the market stays equal the U.S dollar stays strong. As, inflation occurs the exchange rate of the US dollar will fluctuate and have negative impacts. PPP theory assume the prices govern the exchange rate when it is the exact opposite (Varoufakis 2013). The US dollar would flow through a downward cycle until countries with in the market correct it.

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Purchasing power parity (PPP) theory states that the exchange rates between two currencies are in equilibrium when their purchasing power is the same in each of the two countries. (Saunder School of Business) In other words, residents of one country should be able to purchase goods and services at the same price as citizens of any other nation. The price of "basket goods" should be the same in each country. (Amadeus, 2016) This means the exchange rate between two countries should be equal to the ratio of the two countries' level of a fixed basket of goods. When a country's domestic price level increases, i.e. a country experiences inflation, that country's exchanges depreciates to return it to PPP.

PPP operates under the "law of one price", which states that identical goods should sell for the same price in two separate markets when there are no transportation or transaction costs. (Saunders)

Inflation, which is over-expansion of money supply, can lead to a depreciation in a country's currency. The money supply is not just cash, but also credit, loans and mortgages. Money supply expands through the expansionary policy by the Federal Reserve. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. When a country's money supply expands, the amount of money available increases; this changes the relative demand-and-supply conditions in the foreign exchange market. If the U.S. money supply expands faster than output, the dollar will be more abundant, and hence the dollar will depreciate in the foreign exchange market against countries with lower growing currencies. (Hill, 2015)