Parity Conditions in International Finance

International Finance (B 645)

Outline

Purchasing Power ParityInternational Fisher EffectInterest Rate Parity

Purchasing Power Parity (PPP)

Absolute VersionIndividual goods and services tend to sell for the same price everywhere. If prices differ, arbitrage would take place which would change the price and/or the exchange rates to force an equilibrium

Relative VersionThe rate of change in the prices of the products should be somewhat similar when measured in a common currency

PPP Continued…The exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price

levels of the two countries. If Ihome > Iforeign, foreign currency must appreciate relative to home currency to offset the advantage of more buying power of home currency.Similarly, if Ihome < Iforeign, foreign currency must depreciate relative to home currency to offset the advantage of more buying power of foreign currency.

US Inflation = 4%Japanese Inflation = 2%The dollar value of yen must rise by 2%

Some Lessons of PPPExchange Rate Changes may indicate nothing more than the reality that countries have different inflation ratesExchange rate movements should cancel out changes in the foreign price level relative to the domestic price level with no effect on the relative competitive position of domestic firms and their foreign counterpartsIn terms of currency changes affecting relative competitiveness, the focus must not be on nominal exchange rate changes, but instead on the real purchasing power of one currency relative to the other currencyIf changes in nominal exchange rates are fully offset by changes in the relative price levels, then the real exchange rate remains unchangedImportant implications for exchange rate risk management

If PPP holds, real exchange rate will not change—no effect on competitive strengthDeviation from PPP, however, will lead real exchange gains and losses

Why PPP fails to hold?

Sticky nature of Goods PricesDifferent Price IndicesChanges in Relative Price levelsComposition of the Price Indices