The currency transactions result in a balance of trade in goods and services (current account) or a balance of financial asset flows (capital account). The exchange value of a currency must be such that there is enough balance in both the accounts to sustain future transactions. This is where purchasing power parity comes into play. It is a key determinant of the international balance in the goods market. A similar condition for the capital account is known as interest rate parity, which is a key determinant of the international balance in the financial asset flow.
The relationship between the trend in fluctuation of exchange value of the dollar, for instance, and purchasing power parity (in the long run) or the interest rate parity (in the short run) is clearly evident from the bilateral exchange rate between the US and the individual foreign nation in whose currency you are presently trading.
Purchasing power parity is the equilibrium that must exist between the domestic purchasing power of a currency and its international purchasing power. If the exchange rate is greater than the purchasing power parity, then the currency is considered to be over valued and as a result of this imbalance, the currency is capable of purchasing more goods and services abroad than in the domestic market level.
Interest rate parity plays an essential role in foreign exchange markets, linking interest rates, spot exchange rates and foreign exchange rates. Interest rate parity follows the theory that the interest rate differential between two countries is equal to the gap between the forward exchange rate and the spot exchange rate. In fact, the interest rate parity assumes that the actions of investors trigger corresponding changes in the exchange rates as well.
