Q54. Why does the same amount of money buy less today than when I was a child?

Purchasing power is the amount of a good or service one can command for a given unit of currency. The greater the amount of goods one can buy with, say, €10, the higher the purchasing power of the €10.

In an inflationary period, the purchasing power of currency is diminished, as each €10 buys you less and less goods and services.

In a deflationary period, the purchasing power of a €10 note is increased.

To see this, imagine there is only one good in the world. One day, €10 will buy you 5 units of the good, valued at €2 each. Your purchasing power is 10 / 5 = 2. The next day, due to inflation, €10 will only buy you 3 units, because each good has risen in price. Similarly, the day after, because of a deflation, €10 will buy you 8 units of the good.

Q55. What determines the exchange rate between currencies?

The exchange rate of one currency for another gives the amount of currency A in terms of another (currency B). The exchange rate quoted on the news is generally the spot exchange rate. When you hear the euro trading for 0.93 against the US dollar, it means that $1 will buy you €0.93 worth of goods and services. This is a 'direct' currency quote. If the euro becomes more valuable, or appreciates, then you would expect the exchange rate number to decrease - to say, €0.90, reflecting the fact that $1 now will only buy €0.90 worth of goods and services.

The foreign exchange market is one of the largest by volume in the world, with trillions of US dollars' worth of currency changing hands every day. Only a small proportion of this huge amount now represents actual exchange for business trading purposes, the vast bulk being speculation by banks and investors.

Currencies can be fixed with respect to each other by their exchange rates. Each country in the European Union, for example, has a fixed exchange rate with the euro. Currency can 'peg' to other currencies, meaning the country will maintain a rolling series of fixed exchange rates with respect to one or more other currencies. Most Latin American countries are pegged to the US dollar, for example. Other currencies are free-floating, and have the value of their exchange rates determined by supply and demand for the currency each day. Under floating exchange rates, a currency will become more valuable, or appreciate, relative to other currencies, if demand for it is greater than the available supply. Conversely, if demand for a currency is less than the available supply, the currency will depreciate relative to other currencies.

Q56. Why don't Big Macs cost the same in every country?

Purchasing power parity exists when two countries' exchange rates for currency equalise the difference in purchasing power between the two countries.

Think about two currencies, mediated by a flexible exchange rate, which means that, on any given day, the price of euros in terms of dollars changes with the demand for products denominated in the other currency. If we in Europe buy more goods and services from the US relative to their purchases of our goods and services, then the price of that foreign exchange - the exchange rate - will go up.

Now, the higher the price and costs levels are in Europe relative to the US, the greater our imports from the US. High EU prices and low US prices usually means a high price for foreign exchange. The relative change in the exchange rate is in fact proportional to the change in the price levels in the two trading countries. This is purchasing power parity at work, so that, all things being equal, the EU/US exchange rate is given by:

EU / US exchange rate = EU prices / US prices

What has this got to do with Big Macs? If you could buy a Big Mac in Europe for €2 and the exchange rate between the euro and the US dollar was €0.50 for every $1, then if purchasing power parity holds, you should be able to buy a Big Mac in the USA for $1. The Economist magazine routinely publishes the prices of Big Macs from all over the world to check for purchasing power parity. The Big Mac is sold in about 120 countries, so the Big Mac purchasing power parity indicator is the exchange rate that would mean hamburgers cost the same in America as abroad, if purchasing power parity held. Comparing actual exchange rates with those implied by the purchasing power parity exchange rate above can help us decide whether a currency is under-valued or over-valued.

It is precisely because currency exchange rates are subject to other pressures, not just purchasing power parity, that sometimes Big Macs do not cost the same in every country.

 
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