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