Purchasing Power Theory is the idea that in a stable market place, the
correlation between the interchange rates of various nations should be in
the same ratio as the price of a fixed goods and services. In other words,
there exists a difference between the procuring strength of currencies and
their exchange rates. There are different ways of expressing this, but most
commonly it is expressed as:
This theory considers exchange rate as the price which brings into
equilibrium the supply and demand for home currency in exchange for
foreign exchange arising from the international transaction in goods,
services, and financial assets. The impact of a change in the stance of
analyzing exchange rate determination and an easy monetary policy will
tend to lead to an ex-ante BOPs deficit. An increase may worsen the current
account, while lowering interest
In the economic approach, the exchange rate between any two currencies
determined by relative money demand and money supply between the two
countries. Relative quantities of local and foreign bonds are irrelevant. The
portfolio-balance approach ensures relative bond supplies and demands as
well as related money-market conditions to determine the exchange rate.
Hence, the essential difference is that monetary-approach (MA) models
assume domestic and foreign bonds to be perfect substitutes, whereas
portfolio-balance (PB) models assume imperfect substitutability.