Commodity market and foreign exchange market – the relationship between them. How does it work?

Traders trading in the foreign exchange market constantly have to deal with such expressions: the strengthening of the dollar led to a decrease in the price of gold, or, for example, the euro supported the price of oil. Although such explanations are often given after the event has occurred, we feel the connection between the commodity and foreign exchange markets regardless of whether we trade in the foreign exchange market or have nothing to do with it.

Theoretically, inflation is the connection between goods and money, and it doesn’t matter what is in our wallet — dollars, euros, rubles, British pounds or Indian rupees. If a week ago we refueled a car at 40 rubles per liter, and now gasoline costs already 50 rubles, then the ruble, in terms of gasoline, has fallen in price by 25% in a week, while gasoline has risen in price. If gold, in US dollars, cost $ 30 per gram in June 2009, and in June 2019, gold costs $ 43, then this means that over 10 years the price of gold in US dollars has increased by 43%, and the dollar has fallen in price.

These are simple and understandable to everyone examples of how goods and money are connected, but how can we use it for trade, and why is the connection between the commodity and foreign exchange markets a fundamental law determining the value of exchange rates? Let’s try to figure it out.

Purchasing Power Parity Theorem

The purchasing power parity theorem is formulated as follows: “The price of goods in one country cannot exceed, the price of goods in another country is more than the value of the cost of transporting goods between the two countries.”

At the same time, the normal profit of the merchant and the conversion of the standards of one country into the standards of another country are included in the cost of transportation (Fig. 1). It is also theoretically assumed that artificial trade barriers do not exist.

where, Py is the price of the product in country y; Px– the price of goods in country x; Eyx – exchange rate; Zy – the normal profit of a businessman, transportation costs, etc.

If we assume that the rate of return of a businessman in both countries is approximately equal, i.e. Zy = Zx, then equation (1) on parity can be further simplified by reducing the rate of return. Then, ideally, the exchange rate will be equal to a simple ratio – the price of goods in country x divided by the price of goods in the country.

Eyx = Py / Px (2)

It is clear that equation (2) reflects an ideal currency, in an ideal world where there are no trade barriers, with an interest rate equal in both countries, but with all its simplicity, it reflects the dependence of the exchange rate on commodity prices as well as possible.