Long-term movements in exchange rates are driven by fundamental macroeconomic structural shifts, primarily differences in inflation rates across countries. The core economic model used to track this relationship is Purchasing Power Parity (PPP).
The Absolute and Relative PPP Paradigms
- Absolute PPP: States that the exchange rate between two currencies should equal the ratio of the price levels of a standardized basket of identical consumer goods in each country, following the classical law of one price.
- Relative PPP: Analyzes the pace of change, proving that the percentage appreciation or depreciation of a currency over time is driven by the inflation differential between the domestic and foreign economies:
[Domestic Inflation Spikes High] ---> Local Purchasing Power Drops ---> Currenc