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The currency exchange rates of every country in the world are based on a concept called the Purchasing Power Parity (PPP). This concept says that a currency’s value is based upon the total number of products that can be bought with a single unit of that currency. So if USD$1 buys two McDonald’s apple pies in the US, while RMB1 (Chinese Renminbi) buys only one McDonald’s apple pie in China, then the exchange rate between the US and China would be RMB 2 = USD$1, since an American would then be able to exchange his US dollars for Chinese RMB in China and be able to buy the same number of pies there as he would have in the US.

In the modern world, exchange rates do not always adhere to the PPP. The exchange rates are decided by supply and demand, so if the demand for a currency rises while its supply stays constant, its price or exchange rate rises against all other currencies. The exchange rate decided by supply and demand is the nominal exchange rate, while the rate prescribed by PPP is the real exchange rate. In foreign exchange transactions, the nominal exchange rate is honored, while the real rate is simply used by economists to study a country’s real prosperity.

Many developing countries influence the nominal exchange rates of developed countries so they can export their produce to them. As the developed country’s currency rises against the developing country’s, it becomes more profitable for the developed country to import products from the poorer country.

However, if real exchange rates were to be used in daily transactions instead of nominal exchange rates, there would be no opportunities for the developing countries to export to the developed countries, since PPP would ensure that the same dollar buys the same two apple pies in both the US and China.

Subsequent to this, the developing country, say China, would export huge quantities to the richer country, say US. This would make an average American richer and an average Chinese poorer. However, despite the inflow of goods from China and the increased PPP for the US, the US`s real exchange rate is still worse off than its nominal exchange rate, which has been artificially propped up by China.

A prudent American would use the opportunity to take his/her dollars and change them for Chinese RMB and move to China. Since the nominal exchange rate between the US and China is in the favor of the US, it would be wise to convert all available dollars before China changes its mind and stop inflating the US dollar by depegging its RMB from the US dollar. This would lower the demand for the US dollar and bring the ollar to its true value, which should be close to its real value as decided by PPP.

As things stand, both the US and China are set to suffer severe recessions. China is unlikely to depeg the RMB until the inflationary pressures in the US rise and China is required to buy more and more US dollars to keep the dollar high in value. For at least the next few quarters, the US would see deflation, and that gives a suitable opportunity to Americans to exchange their dollars since the US dolllar should become stronger in the near future.

Source: Want to Protect the Dollar? Move to China