Purchasing power is affected by inflation rates. People in low inflationary country have high purchasing power than people in low inflationary country. High purchasing power leads to high demand for goods or services in that country.
Parity means difference or discrimination. Purchasing power parity theory discriminates between two different currencies using different inflation rates in different country.
Inflation increases price of goods or services. Inflation rates are different in different countries means that price of the goods of same quality will differ. This gives the opportunity of risk free profit making by purchasing from low inflationary country and selling to high inflationary country.
Inflation rate parity theory states that exchange rate will move to make the price of goods in different countries equal so that risk free profit making is not possible. Increased demand for goods in low inflationary country will raise demand for that country currency which will lead to increase in exchange rate of that low inflationary country currency. Therefore, making purchase of goods in low inflationary country equally costly to buyer in high inflationary country.
Using inflation rate parity theory, we can estimate forward rate for foreign currency by using inflation rates in home country and foreign country as weighting for spot rate.
