According to Madura (2015), the absolute form of Purchasing Power Parity (PPP) theory states that the prices of the same basket of products in two different countries should be equal when measured in a common currency. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices converge. PPP theory would likely to hold between the United States and China. There is a theory that floats around out there called the ‘Purchasing Power Parity theory of the Exchange Rate. The theory, stripped right down, amounts to this: the ‘correct’ value of the exchange rate will be the old exchange rate times the change in the price level in one of the two countries involved divided by the change in the price level of the other of the two countries involved. Madura states that one of the main theories behind the lack of stability within the concept of PPP involves both confounding effects and the lack of substitution for some traded goods (Madura, 2015).
Changes in international trade result from inflation differences and affect the exchange rate (by affecting the demand for the currency and the supply of the currency for sale). China has had a trade deficit for a long time. The underlying force of IFE is the differential in expected inflation between two countries, which can affect trade and capital flows. The effects on the exchange rate are more likely to occur if free trade is allowed, and the currency’s exchange rate is