Overvaluation of Currencies and Exchange Rates

The foreign exchange rate is often counted upon to reflect one currency's value compared to another. It presumes that the exchange rate is an accurate representation of the currency's real value.

However, in the real world, certain factors contribute to making the official exchange rate make the currency seem more valuable than it really is. This is what we mean by overvaluation. The flipside also exists: sometimes the official rate does not give the currency much value to how things really are.

Why do currencies become overvalued? In a country that makes use of the fixed exchange rates, this phenomenon is quite common since the government pegs the exchange rate at a static value. The exchange rate does not really show the true value of the currency because the government chooses not to allow market forces to determine its value. But even so, overvaluation can occur even if a country's exchange rate is floating. The government might intervene from time to time and this could interfere with the value of the currency.

One way to determine if a currency is overvalued or not is through the use of the Purchasing Power Parity (PPP) exchange rate. The PPP exchange rate is defined as that rate that equalizes the prices of a select basket of goods that are available in both countries.

The PPP exchange rate is then compared with the official exchange rate to determine if the currency is undervalued or overvalued. Because we are comparing a basket of goods that are available in both, analyzing their prices and how these prices compare in both countries can tell us if the exchange rate is reflective of the actual purchasing power of that currency.

An example of a PPP test is the use of the Big Mac. Since there are McDonald's outlets in almost all countries, the prices of Big Macs in the different countries can be compared. For instance, in 2006, a Big Mac in Britain costs roughly around 1.99 while in the U.S., it is priced at .41. If we want to determine the PPP of the pound to the dollar, we will first have to divide the price of one Big Mac in pounds to that of a Big Mac in dollars. That will give us a PPP of 0.58. If we compare this with the actual exchange rate of pounds to dollars at that time, which was 0.50, we then come to the conclusion that the pound was overvalued against the dollar in 2006 by around 13.8 percent.

An overvalued currency has certain implications. If you're a tourist and you go to a country where the pound is overvalued compared to the local currency there, then things will be relatively cheaper for you. On the other hand, an undervalued pound may mean that things in the country you're visiting might appear to be a tad more expensive than before. Businesses engaging in the import and export of goods will also find that if the pound is overvalued, imports become cheaper and British products being sold overseas become more expensive.