The overvaluation of a country's currency exchange rate will have three effects on the country: the decrease of foreign exchange supply, the increase of foreign exchange demand and the balance of payments deficit.

The overvaluation of exchange rate can actually show that the appreciation of domestic currency is higher than the difference between domestic inflation and foreign inflation, that is, the exchange rate of domestic currency is higher than the relative purchasing power parity.

According to the relative purchasing power theorem, the actual purchasing power of each country will be reduced due to different degrees of inflation, so the exchange rate will deviate from the old parity according to the proportion of inflation in each country.

Extended data

In the free foreign exchange market, the exchange rate is determined by the relationship between foreign exchange supply and demand, and there is generally no overvaluation. However, when the official foreign exchange agencies set the exchange rate, there will be a phenomenon of deliberately overestimating the value of the domestic currency and raising the exchange rate of the domestic currency for some purpose.

For example, inflation occurred in the United States and Japan. Inflation in the United States has increased the price index from 65,438+000% to 200%, while inflation in Japan has increased the price index from 65,438+000% to 65,438+040%. Assume that the original exchange rate of USD against JPY is: 1 USD = 1.

If the United States uses the price index lower than its inflation (such as 175%) to calculate the exchange rate, the exchange rate is: 1 USD = 180×80%= 144 yen.