Question

According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain.

Short answer

In terms of the Purchasing Power Parity theory, due to a higher inflation rate in Australia compared to New Zealand, the Australian dollar should depreciate against the New Zealand dollar. This is to maintain the same purchasing power for the same basket of goods in both countries.

Step-by-step solution

Understanding Purchasing Power Parity (PPP)

The theory of Purchasing Power Parity (PPP) stipulates that for two countries, the exchange rate should adjust so that a basket of goods costs the same amount in either country. If one country's inflation rate is higher, it means the currency is depreciating since more of the currency is needed to purchase the same goods.

Identify the country with higher inflation

According to the exercise, Australia has a higher inflation rate than New Zealand.

Analyze the impact on the exchange rate

When a country experiences higher inflation, the value of its currency decreases relative to other currencies. In this case, assuming that New Zealand's inflation remains unchanged, the Australian dollar should depreciate against the New Zealand dollar in order to maintain PPP.

Summing it up

In light of the PPP theory, a higher inflation rate in Australia as opposed to New Zealand would cause the value of the Australian dollar to decrease relative to the New Zealand dollar so that the same basket of goods cost the same in both countries. The depreciation of the Australian dollar would help restore parity in terms of purchasing power by making goods in Australia less expensive when bought with New Zealand dollars.

Key concepts

Exchange Rate

The exchange rate is a critical concept in understanding global economics and how currencies interact. It represents the value of one country's currency in relation to another's. Exchange rates fluctuate due to various factors, including market demand, geopolitical events, and economic policies.

In terms of purchasing power parity (PPP), exchange rates are expected to adjust in a way that equalizes the price level of a basket of goods between two countries. This means that if Country A has higher inflation than Country B, the exchange rate should shift so that consumers from both countries can buy the same amount of goods for the same amount of money after conversion.

Exchange rates can be influenced by:

• Interest rates: High-interest rates offer lenders in an economy a higher return relative to other countries. As a result, higher interest rates attract foreign capital and cause the exchange rate to rise.
• Political stability: A stable political environment can bolster the strength of a country's currency.
• Economic performance: Better economic performance can result in an appreciation of the currency.

Inflation Rate

Inflation is a crucial economic indicator, measuring how prices for goods and services increase over time. A high inflation rate means that the purchasing power of that country’s currency is falling, and more money is required to buy the same items.

Inflation rates influence many aspects of the economy, including exchange rate adjustments. When inflation is higher in one country compared to another, it typically leads to a depreciation of that country's currency. This is because inflation erodes the value of the currency domestically, requiring more of it to purchase goods.

Key impacts of inflation include:

• Reduced purchasing power: As prices increase, the value of money decreases, purchasing fewer goods and services over time.
• Impact on savings: High inflation can erode the value of money put away in savings accounts unless interest rates exceed inflation rates.
• Influence on exchange rates: As explained through PPP, higher inflation typically leads to currency depreciation relative to trading partners.

Currency Depreciation

Currency depreciation occurs when the value of a nation's currency weakens relative to one or more foreign reference currencies. This decline impacts trading dynamics since the domestic currency buys fewer foreign goods and services.

In the context of purchasing power parity, higher inflation in one country leads to currency depreciation. The idea is that as domestic currency loses its purchasing power, more currency is needed to buy the same amount of foreign goods, affecting the exchange rate.

Effects of currency depreciation include:

• Enhanced competitiveness: Domestic products become cheaper for foreign buyers, potentially boosting exports.
• Imported inflation: Imported items become costlier, leading to a rise in the general price level.
• Capital outflow: Investors might shy away from holding assets in depreciating currencies, seeking stable or appreciating ones instead.

By understanding these impacts, businesses and policymakers can react to the dynamic nature of currency values in the global market.