Equilibrium Exchange Rate Calculator

Equilibrium Exchange Rate Calculator (PPP Method)

Total cost of a representative basket of goods in the domestic country.

Total cost of the same basket of goods in the foreign country.

Current exchange rate expressed as Currency A per 1 unit of Currency B.

function calculateEquilibrium() { // Get inputs by ID var priceDomInput = document.getElementById('priceDomestic').value; var price ForInput = document.getElementById('priceForeign').value; var marketRateInput = document.getElementById('marketRate').value; // Convert to numbers var pDom = parseFloat(priceDomInput); var pFor = parseFloat(priceForInput); var mRate = parseFloat(marketRateInput); // Validation if (isNaN(pDom) || isNaN(pFor) || isNaN(mRate) || pFor === 0) { alert("Please enter valid positive numbers for all fields. Foreign Price Level cannot be zero."); return; } // Calculate PPP Equilibrium Rate (S = P_domestic / P_foreign) var pppRate = pDom / pFor; // Calculate Percentage Deviation ((Market – PPP) / PPP) * 100 // If Market > PPP, Foreign currency (B) is expensive relative to equilibrium. var deviation = ((mRate – pppRate) / pppRate) * 100; // Determine Verdict var verdictText = ""; var verdictClass = ""; // Logic: The rate is Price of A / Price of B. // If Market Rate is higher than PPP, you pay more A for B than goods justify -> B is Overvalued. if (deviation > 0) { verdictText = "Foreign Currency (B) is Overvalued by " + deviation.toFixed(2) + "%"; verdictClass = "eer-status-over"; } else if (deviation < 0) { verdictText = "Foreign Currency (B) is Undervalued by " + Math.abs(deviation).toFixed(2) + "%"; verdictClass = "eer-status-under"; } else { verdictText = "Fairly Valued (At Equilibrium)"; verdictClass = "eer-value"; } // Display Results document.getElementById('resEquilibrium').innerHTML = pppRate.toFixed(4) + " A/B"; document.getElementById('resMarket').innerHTML = mRate.toFixed(4) + " A/B"; document.getElementById('resDiff').innerHTML = deviation.toFixed(2) + "%"; var verdictEl = document.getElementById('resVerdict'); verdictEl.innerHTML = verdictText; verdictEl.className = "eer-value " + verdictClass; // Show result box document.getElementById('eerResult').style.display = "block"; }

What is an Equilibrium Exchange Rate?

The equilibrium exchange rate is the long-term theoretical value of a currency pair where the supply and demand for the currencies are balanced, resulting in a sustainable external position. Unlike the spot market rate, which fluctuates continuously due to speculation, interest rates, and geopolitical news, the equilibrium rate focuses on fundamental economic factors.

This calculator uses the Purchasing Power Parity (PPP) approach, derived from the Law of One Price. It suggests that in the long run, exchange rates should adjust so that an identical basket of goods and services costs the same in both countries when expressed in a common currency.

How to Calculate Equilibrium Exchange Rate (PPP)

The fundamental formula for the absolute Purchasing Power Parity exchange rate is calculated by comparing the price levels of two different countries.

Formula:
E = P_d / P_f

Where:

• E = The Equilibrium Exchange Rate (Units of Domestic Currency per 1 Unit of Foreign Currency).
• P_d = The price level of a basket of goods in the domestic country (Currency A).
• P_f = The price level of the same basket of goods in the foreign country (Currency B).

Understanding the Results

Once you have calculated the implied PPP rate, you can compare it to the current market spot rate to determine currency valuation:

• Overvaluation: If the current market rate is higher than the PPP rate, the foreign currency is considered overvalued (expensive) relative to the domestic currency. This implies the market rate may fall in the long term.
• Undervaluation: If the current market rate is lower than the PPP rate, the foreign currency is considered undervalued (cheap). This implies the market rate may rise in the long term.
• Fair Value: When the market rate equals the PPP rate, the currencies are in equilibrium regarding their purchasing power.

Why does this matter?

Investors, multinational corporations, and policymakers use equilibrium exchange rate models to:

1. Identify potential arbitrage opportunities in international markets.
2. Forecast long-term currency trends beyond short-term volatility.
3. Assess the economic health and trade competitiveness of a nation. If a country's currency is significantly overvalued, its exports may become too expensive for foreign buyers, leading to a trade deficit.

Limitations of the Model

While PPP is a powerful tool for estimating equilibrium, it has limitations. It assumes zero transaction costs (no shipping or tariffs) and identical goods. In reality, non-tradable goods (like housing or haircuts) and government interventions can cause the market rate to deviate from the PPP equilibrium for extended periods.