Effects of inflation on purchasing power parity.

Effects of inflation on purchasing power parity.

If the rate of inflation of two countries differs, then the relative prices of products of the two nations will also vary. These products could be goods or any services in the countries.  The purchasing power theory links the price of a good to the rate of exchange. Inflation reduces the currency value in a country, hence reduces its purchasing power (Rogoff, 1996). If a countries inflation rate increases to twenty percent, then its currency value goes down by twenty percent and it will buy goods that a twenty percent less of value. The purchasing power theory holds that the countries prices will change on inflation differences.

References

Rogoff, K. (1996). The purchasing power parity puzzle. Journal of Economic literature, 34(2), 647-668.