Purchasing Power Parity
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Transcript of Purchasing Power Parity
Purchasing Power Parity
Before we discuss PPP theory let us dig out something from our previous knowledge
Exchange Rate Spot Rate Forward Rate Direct and Indirect Quote Arbitrage Purchasing Power Inflation Perfect or Efficient markets
We will try to find the answers for the following? Can we predict the changes in exchange
rate? Does inflation affect exchange rate? If it does, how? Does interest rate affect exchange rate? If it does, how? How can we arrive at a more proper and
actual exchange rate?
Theories of exchange rate determination
Purchasing Power Parity
International Fisher Effect
The Interest Rate Parity
Purchasing Power ParityThe PPP theory focuses on the inflation –
exchange rate relationships.If the law of one price holds for all goods
and services, we can obtain the theory of PPP.
LAW OF ONE PRICE
Law Of One PriceLaw of one price states “ In an efficient all
identical goods must have only one price”Identical goods should sell at identical
prices in different marketsIf not, arbitrage opportunities existAssumes that there will be no shipping costs,
tariffs, taxes….etc.Relates to a particular commodity, security,
asset etc..
◦ Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate
• Example:
Price of wheat in France per bushel (p€) = 3.45 €
Price of wheat in U.S. per bushel (p$) = $4.15
S€/$ = 0.8313 (s$/€ = 1.2028)
Dollar equivalent price
of wheat in France = s$/€ x p€
= 1.2017 $/€ x 3.45 € = $4.1676
P€ = S€/$ P$
Historical back drop A Swedish economist Gustav Cassel introduced the
PPP theory in 1920s
Countries like Germany, Hungary and Soviet Union experienced hyperinflation in those years due to World War I
The purchasing power of these currencies declined sharply
The currencies depreciated sharply against more stable currencies like the US dollar
Absolute PPP
Law of one price extended to
a basket of goods If the price of the
basket in the U.S.
rises relative to the
price in Euros, the US
dollar depreciates
Have a lookIf the price of the basket in the U.S. rises relativeto the price in Euros, over a period of three days
May 21 : s€/$ = P€ / PUS
= 1235.75 € / $1482.07 = 0.8338 €/$
May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$
Has the US dollar appreciated or depreciated?
Mathematically , Absolute PPP postulates that
Pa is the general price level in country A
Pb is the general price level in country B
sa/b is the exchange rate between currency of country A
and currency of country B
sa/b = Pa / Pb
Statement
The absolute PPP postulates that the equilibrium
exchange rate between currencies of two countries
is equal to the ratio of the price levels in the two
nations.
Thus, prices of similar products of two
countries should be equal when measured
in a common currency as per the absolute
version of PPP theory
Deviations from absolute PPP
Simplistic model
Transportation costs Tariffs and
taxes Consumption
patterns differ Non-traded
goods & services
Imperfect Markets
Sticky prices Markets don’t
work well
Statistical difficulties
Construction of price indexes
Different goods Price index
includes tradable and non tradable
goods
Big Mac and PPP