Kenneth R. Szulczyk

Change in the currency exchange rate is the percent change in the spot exchange rates. Then
we substitute the relative price levels into the equation, shown in Equation 6.

 

 

1

1

1 1

1

0

(^0) 





d

f

d

f

d

f

d d

f f

T

+ π

+ π

=

P

P

P

P

P + π

P + π

=

S

S S

e= (6)

We use a linear approximation to yield Equation 7.

e π f π d (7)

For example, the annual U.S. inflation rate equals 3% while Mexico's inflation rate is 25%.
If we defined the domestic currency as the peso, then the Mexican peso depreciates
approximately 22% per year while the U.S. dollar appreciates roughly 22% per year.
International investors prefer to hold currencies with low inflation rates because inflation erodes
the value of currency. Thus, consumers and businesses would hold U.S. dollars and would sell
their Mexican pesos. Consequently, the relative PPP usually holds in the long run for countries
with large inflation rate differences. Countries experiencing high inflation experience
depreciating currencies.
We modify the relative PPP to allow analysts to determine whether a country has a
competitive export industry. We begin with Equation 6 and rewrite it as Equation 8.

1

1

1



d

f

+ π

+ π

e= (8)

Then we add a positive one to both sides of the equation and then divide by (e – 1) to yield
Equation 9.

+ π  e

+ π

=

d

f

1 1 

1

1 (9)

Then we replace the one with a k that represents the competitive ratio. For example,
Malaysia, experiences a 5% inflation rate, and we defined Malaysia as the domestic currency.
Meanwhile, the United States experiences a 2% inflation rate. If the ringgit had depreciated
against the U.S. dollar by 1%, subsequently, we calculated the competitiveness ratio for
Malaysia, where k = 0.981 in Equation 10. Consequently, our calculation does not equal one,
and the higher inflation rate and the depreciating currency keep Malaysian manufacturing
competitive, boosting its export industries.