What is exchange rate parity (currency parity)?
Exchange rate parity (exchange rate parity) – This is the legally established ratio between two currencies, which is the basis of the exchange rate.
What is exchange rate parity for?
Parity is the basis for the formation of exchange rates, since it determines their ratio in the manner prescribed by law. That is, using parity, the ratio of the national currency to the currencies of other states is determined. Parity can be determined using any currency unit.
At the moment, there are two modes for the exchange rate:
- fixed exchange rate;
- floating exchange rate.
How did modern currency parity come about?
Until 1978, the parity of exchange rates was determined by the gold content of currencies, i.e. the amount of gold contained in the monetary units of countries. Then, for countries in the International Monetary Fund (IMF), the basis of calculation was “Special Drawing Rights” (SDR) – a type of international currency that is used only for intergovernmental settlements through central banks.
Since 1979, the European Monetary Union (EMU) entered into force, which began to fix the obligations of the member states of the European Economic Community (EEC) to maintain currency parity within the established limits. Among the important factors affecting currency parity, it is necessary to note the state of the trade balance of countries, the volume of money supply, the rate of inflation, the degree of government intervention, etc.
How is currency parity calculated?
In economics, the exchange rate is determined using purchasing power parity. When using this method, exchange rates are obtained conditional, since there are no exact indicators for the consumer basket due to the difference in the structures of the provision of goods and services in different countries. In practice, currency parity is confirmed using long-term planning and currency parity calculations.
Purchasing power parity is a ratio that expresses the number of two or more units of different currencies required to purchase a specific set of goods and services. The meaning of purchasing power parity is to show how much a set of goods and services in a country is worth, expressed in monetary units of other states.
This ratio is expressed by the formula:
P = r X Pi or r = P / Piwhere
- Pi and P – the price of a specific consumer basket in another state and country for which the calculation is made;
- r – indicator of the currency rate or the value of the foreign currency used for the calculation.
What is currency parity in Forex?
On Forex under parity of exchange rates means equality in the value of currencies relative to each other. In this case, the quotation of such a currency pair is equal to one. Example EUR / USD = 1.0000.
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