According to PPP, exchange rates adjust to equalize tradable goods prices between countries. Therefore, if money supply rises, they’ll be more supply of money chasing too few goods. Thus, currency has to be depreciated to restore equilibrium. Also, as a result, there will be a reduction in interest rates as well.
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Sometimes known as the “law of one price”, 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. Therefore, the exchange rate must move towards a long-term equilibrium value that ensures this is true. The formula is as follows:
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If we have a look at forex ads in the newspaper, there are many misleading advertisements that say that you don’t need to know anything about economics or the fundamentals of the foreign exchange market to be successful in forex. Obviously the contribution of economics to the field of currency analysis plays a huge role, especially in equilibrium exchange rate models, an important tool for analyzing long-term exchange rate trends where they basically give you the big picture of the foreign exchange market.
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