How do the markets determine at what particular spot rate a currency will trade, or what relationship a forward exchange rate should bear to the spot rate?
Economists have put forward a number of theories to try to answer this question. The first theory to be developed was that of purchasing power parity. It seems intuitively plausible that the exchange rate between two currencies should be related to the purchasing power of each. For example, suppose that the same CD can be bought in the UK for £8 and in the USA for $12. It seems reasonable to believe that £8 should be equal in value to $12 (or £1 to $1.50). If the £/US $ exchange rate deviates from this level, consumers would rush to buy CDs in the cheaper country (perhaps over the internet), thus exerting pressure to return the exchange rate to its equilibrium level. Experience tells us that purchasing power parity, at least in this simple form, rarely works. People and companies take factors other than relative prices into account when deciding where to buy goods and services. The costs, risks and feasibility of making the purchase in an overseas territory, indirect taxes such as VAT,
Related Questions
- How do the markets determine at what particular spot rate a currency will trade, or what relationship a forward exchange rate should bear to the spot rate?
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