The most popular method of forecasting exchange rates is called the theory of purchasing power parity (PPP). The PPP principle is based on the theoretical “law of one price”, according to which identical goods in different countries should have the same price (Jabbie & Jackson, 2020). For example, according to this rule, a pencil in Canada should cost as much as the same pencil in the United States, taking into account the exchange rate and excluding the costs of exchange and transportation. In other words, there should be no reason for speculation when someone buys pencils cheaply in one country in order to sell them profitably in another (Majumder & Ray, 2020).
Based on this PPP theory, the exchange rate should change in such a way as to compensate for price increases due to inflation (Papell & Prodan, 2020). For example, let’s assume that prices in the United States should increase by 4% in the coming five years, while in Canada by only 2%. The inflation differential will be:
4% – 2% = 2%
This means that the rate of price growth in the United States will be faster than those in Canada. According to the principle of purchasing power parity, the US dollar should depreciate by about 2% in order for the prices of goods in the two countries to remain relatively the same. For example, if the exchange rate was 90 US cents per Canadian dollar, then according to the PPP method, the projected rate will be:
(1 + 0.02) x (0.90 US dollars for 1 Canadian dollar) = 0.918 US dollars for 1 Canadian dollar
This means that the Canadian dollar should rise to 91.8 US cents per dollar in a year. In the next year, considering the economic conditions remain the same, we have
- (1 + 0.02) x (0.918 US dollars for 1 Canadian dollar) = 0.936 US dollars for 1 Canadian dollar
- One more year
- (1 + 0.02) x (0.936 US dollars for 1 Canadian dollar) = 0.954 US dollars for 1 Canadian dollar
- Another year
- (1 + 0.02) x (0.954 US dollars for 1 Canadian dollar) = 0.973 US dollars for 1 Canadian dollar
- In five years
- (1 + 0.02) x (0.973 US dollars for 1 Canadian dollar) = 0.992 US dollars for 1 Canadian dollar.
References
Jabbie, M., & Jackson, E. A. (2020). On the Validity of Purchasing Power Parity: The Case of Sierra Leone 1. Journal of Advanced Studies in Finance, 11(1), 18-27.
Majumder, A., & Ray, R. (2020). National and subnational purchasing power parity: a review. Decision, 47(2), 103-124. Web.
Papell, D. H., & Prodan, R. (2020). Long-run purchasing power parity redux. Journal of International Money and Finance, 109, 102260. Web.