PURCHASING POWER PARITY THEORY

Purchasing power parity theory (PPP) holds that the exchange rate between two currencies is determined by the relative purchasing power as reflected in the price levels expressed in domestic currencies in the two countries concerned. Changes in the exchange rate are explained by relative changes in the purchasing power of the currencies caused by inflation in the respective countries. The concept of Purchasing power parity theory (PPP) is traced to David Ricardo, but the credit for stating the law in an orderly manner is given to the Swedish economist Gustav Cassel who proposed it in 1918 as a basis for resumption for normal trade relations at the end of First World War. The PPP theory is stated in two versions : i) ii) The stronger absolute version, and The diluted relative version

ABSOLUTE VERSION OF PPP The absolute version of PPP is based on the law of one price. This law states that under conditions of free market with the absence of transportation costs, tariffs and other frictions to free trade, the price for identical goods should be the same at any marketwhen measured in terms of a common currency. To give an example, suppose a particular quality of coffee seeds cost Rs 100 a kg in India and the same commodity costs USD 2 in USA. The exchange rate between US dollar and Indian rupee in the market will be Rs 50 so that when the dollar price of coffee is converted into rupees will be the same Rs 100 as prevailing in the domestic market. If the exchange rate in the market is anything other than rs 50 it will lead to arbitraging opportunities. The arbitraging operations will ultimately lead the exchange rate to the equilibrium level. To explain how arbitraging operations will restore the exchange rate to Rs 50 per dollar, let us suppose that the market rate for dollar is Rs 45. In the absence of transaction costs, traders in india will find that coffee is priced low in terms of dollars as compared to its rupee price. They will find it advantageous to buy coffee in USA and sell in the domestic market. Suppose a trader imports 1000 kgs of coffee. He will pay Rs 90,000 to acquire the required USD 2,000 from the market. He can sell 1000 kgs of coffee in the domestic market at Rs 100 a kg and earn Rs 1,00,000. This results in a profit of Rs 10,000 to the trader. Similar operations will be done by all the traders in India. The combined effect of the operations of all the traders in India is that the demand for dollars increases in the foreign exchange market, pushing its prices in terms of rupees. With successive deals the dollar keep as appreciating. The arbitrating profit is reduced with the appreciation of dollar. For example if dollar moves to Rs 47, the net profit is redused to Rs 3 a kg from Rs 5 a kg available earlier. The appreciation of dollar will continue until the arbitrating profit is totally eliminated. That is the level where price of coffee is same when measured in terms of either rupees or dollar. If the ruling exchange rate is Rs 54 per dollar, traders in india will find it advantageous to sell coffee in USA to get higher rupee realization. For instance, a trader can buy 1000 kgs of coffee for Rs 100,000 and

he will realize Rs 1. the domestic currency will depreciate proportionately against the foreign currency. Examples of non-traded goods are housing and personal services like health and haircut.000 in India. Therefore it is granted that the exchange rate in the market may differ from the absolute PPP.80.000 in India and the same set of commodities costs USD 200 in USA . . The absolute version of PPP can be stated symbolically as e = Pd/Pf where e = exchange rate for the foreign currency in terms of the domestic currency. Similar operations by all traders will increase the supply of dollars in the market exerting a downward pressure on its price in terms of rupee. Further. the market may quote Rs 45 per dollar.000 in the US market. In the given example the inflation was 10% in India and 6% in USA. The commodities in any basket are not identical and they may differ in quality. PPP theory does not confine to a single product. no transportation costs and identical commodities. Pd= Price in domestic currency Pf= Price in foreign currency. If the price of the basket of commodities increases to Rs 11000 in India and the basket is now costing USD 212 in USA.movement of goods and services are not free. By selling the dollars in the foreign exchange market at Rs 54.sell them for USD 2.08. In the above example. Transportation costs are a big hurdle in benefitting from lower prices in another market. if the cost of the basket increases to Rs 11. The extent to which the rupee will depreciate is the difference in the inflation rates in the two countries during the period. the dollar will now be traded at Rs 55 to maintain the price parity (indicating depreciation of rupee or equivalently appreciation of dollar). If a basket of commodities costs Rs 10. For instance . when the cost of a basket of commodities is Rs 10. While the law of one price relates to a single product. RELATIVE VERSION OF PPP The absolute version of PPP is based on unrealistic assumptions of free trade.000 in India and USD 200 in the USA. The rupee will depreciate approximately by 4% to quote about Rs 46.000 and thus gain Rs 8000. there are certain goods which do not enter international trade. Instead of a single commodity we may consider a basket comprising a variety of products. the rupee will suffer a depreciation in relation to dollar. If the price in the domestic market rises relative to the price level in the foreign market. The exchange rate will move to a level where arbitrating is no more possible. the dollar will be quoted at Rs 50 in the foreign exchange market. while the price does not change in USA. What is expected is that the exchange rate will move along with the relative changes in prices in the two countries.

if dollar earlier in the market at Rs 45.70 in practice . the change in the nominal exchange rate is expected. For computing the real exchange rate there should be a base period exchange rate. Current nominal exchange rate is discounted for the inflation differential to arrive at the real exchange rate. et = 45* (1. When the inflation rate in two countries differs.92 as computed . A change in the nominal exchange rate does not alter the export competitiveness of the countries . the PPP between the dollar and rupee was maintained.1/1. If the inflation adjusted exchange rate is higher than the base period exchange rate.In order to main the PPP. New exchange rate/ Old exchange rate = Proportionate change in domestic price/ Proportionate change in foreign price New exchange rate /45 = (11000/10000)/(212/200) = Rs 46. If the inflation adjusted exchange rate is same as the base period exchange rate. Et/45 =(115/100)/(108/100) Et= Rs 47. The PPP will hold if the change in nominal terms equals the inflation differential between the two countries. when the inflation differential was 4% and the nominal exchange rate moved from Rs 45 to Rs 46.00 is now quoted at Rs 45. Therefore. there is no change in the real exchange rate during the period.70 . .40. In the earlier example. price indices are used to compute the PPP. so long as the movement is in accordance with the inflation differential and the PPP is not changed.70 Symbolically this can be stated as et/e = (1+Id)/(1+If) or et = e * (1+Id)/(1+If) where. Real exchange rate is the nominal exchange rate as adjusted for inflation.92 NOMINAL EXCHANGE RATE AND REAL EXCHANGE RATE The exchange rate as quoted in the foreign exchange market are nominal exchange rates.06)= Rs 46. suppose the price index in India and USA are 100 and the exchange rate is Rs 45 a dollar. To begin with. At the end of the period. et= expected exchange rate after period t Id = rate of domestic inflation during period t If= rate of foreign inflation during period t. The exchange rate will move to Rs 47. the price index in India is 115 and in USA is 108. in the place of a basket of goods. the dollar has appreciated by 40 paise in nominal terms. the change in the exchange rate should be proportionate to the change in the relative purchasing power of the currencies concerned. For instance.

each country follows its own composition and assigns its own weights. To the extent the weights assigned to each type differs between the indices. 6. the home currency has depreciated in real terms against the foreign currency. The reasons for this are : 1. This is same as the real exchange rate changes. The exchange rate is now determined not only by movement of goods and services. . 2. If the inflation adjusted exchange rate is lower than thebase period exchange rate. in any country. Inclusion of non-traded goods: The price indices are based on the changes in prices of traded as well as non-traded goods.it is common knowledge that during a given period. In the given example. 4. the exchange rate in the market differs significantly from the PPP. interference in the form of tariffs and other hindrances to free flow of international trade does not permit the arbitrageurs to take advantage of the price differences in two markets. The exchange rates in the market are affected only by changes in the prices of traded goods. the effect of changes in the price of traded goods on the price index varies. Causes for deviation Empirically it is found that PPP holds only in a very long period. Liberalisation of markets : With the liberalization of markets. other than the cost of production. The actual PPP tends to be different from that suggested by the price indices by the inclusion of non-traded goods in the index. the cross border movement of cash for capital transactions and speculative activities have gained greater importance. Govt. against dollar the rupee deviated from PPP by 40 paise. It may be understood that it is the real exchange rate that affects the competitiveness of a country and not the nominal exchange rate changes. There are different price indices like wholesale price index and consumer price index with different constituents. Even if we use the same index in the two countries concerned.there is depreciation of the home currency in real terms. DEVIATIONS FROM PPP Changes in the real exchange rates can be seen as deviations from PPP. 5. Government interference. A price index which includes both traded and non-traded goods is influenced by price changes in both types of goods. all the goods do not undergo price changes to the same extent. Price Indices. 3. During short term and over medium term. Therefore there are no identical indices based on which the inflation differential can be calculated accurately. allowing for the difference due to different bases. Price discrimination by MNCs : Multinational firms adopt the policy of price discrimination by market segmentation leading to the same product being priced differently in different markets. Stickiness of the price of goods price: in many cases the prices of goods are determined by the manufacturers on the basis of various factors.

At the time of borrowing dollar. It is more in the nature of speculative activity.000and invest in India upto a period of 6 months. Investment of the resultant rupee is made in india carrying interest at 6% p. 3.000 at New York at 2% p.000 at 2%. Covered Interest Arbitrage The profit on account of interest rate differential in the money markets of two countries would be reduced by the appreciation of dollar. The operation described above is known as uncovered interest arbitrage . If the appreciation of dollar exceeded 4% per annum. 4.Determination of forward rates Forward rates are determined by the market on the assumption of no arbitraging possibility in the market. If the dollar appreciates during the interregnum of 6 months. Borrow USD 100. Let us say that the riskless interest rate prevalent in the money market in tha USA is 2% and that in the money market of India is 6%. No steps are taken to ensure that dollar will be availableon the due date at a specific rate. the result may be a loss on the combined operations rather than profit as anticipated. 2. the interest gain on the operations will be reduced.a.Suppose a person is willing to borrow upto USD 100.000 into rupees at Rs 50 per dollar. The operation cannot. On the due date. can he be assured of a return of the equivalent of USD 2000 at the end of the period ? The answer is No . to repay the dollar borrowing along with the interest he has to dollars spot.50 respectively. He can acquire dollars at the prevailing rate. Apparently there is a possibility to borrow in USA at 2% and invest the money in India at 6% and thereby earn a profit of 4% per annum. To the extent of the appreciation of dollar. The reason being: 1. . the arbitrageur creates a position in dollar . 2. Lets assume that the spot rate for dollar on the day of initial investment and repayment is Rs 50 and Rs 50. Convert USD 100.a. therefore. The factor that influences the pricing is the interet rates in the money markets of the two countries concerned. which remains open till it is repaid. more rupees per dollar will be required to repay the dollar borrowing. July 1 1. Invest the resultant rupees for 6 months at 6%. strictly be called arbitrage. Realise the investment in rupees along with interest. 3. The dollar is converted into rupee equivqlent at spot rate. He borrows USD 100. The operations involved are: Jan 1 1.

For no arbitrage opportunity to occur.500.a.000. At the time of deciding to borrow and invest.000 Rupee required for USD 101.000. Repay the dollar loan by procuring the required dollars at the spot rate of Rs50. Suppose the July forward for dollar is quoted at Rs 52. In case such a situation prevails.000 Investment a) Principal b) Interest earned @ 6% p. 1. it would be .500 If the dollar had not appreciated. the forward dollar should be at premium at a level that will completely take away the benefit arising out of the interest differential in the money markets.000at Rs 50. to Rs 52. The dollar is at a premium of about 6% p. as against the interest differential of 4% p.00.50. Total realization = a + b = Rs. A true arbitrageur will not take such risks. he would secure his position by procuring dollars in the forward market due on the repayment date.50 The operations give the following results: Borrowing a) Principal b) Interest @ 2% p.000 USD 1..000 Rs. say.51.a.000 . the operation would have resulted in a loss of Rs 1.2.02. If the dollar had appreciated to a higher level.a. 1. Rs. 51.00.50per dollar.000 Rs. 50.50.000 USD 101.00.a.500 )= Rs 49. 51.50.00. Total Due = a+b = USD 100. profit realized due to interest would be Rs.50 per dollar Profit = Rs(51.

The forward premium will fall and stabilize at a level near equivalent to the interest differential. The arbitrageurs will be indulging in spot purchase of dollars and its forward sale. The consequent effect will be upward pressure on the spot dollar and downward pressure on the forward sale. F= forward rate S= Spot rate rd= Domestic rate of interest rf= Foreign rate of interest . If the actual forward margin in the market is higher or lower than the expected level.advantageous to borrow in India (though at a higher rate of interest) and invest in the USA. arbitraging will eliminate the difference. As a way of generalization. The forward margin tends to equal the interest differential. the forward price for the foreign currency can be calculated as follows: F =S (1+rd)/(1+rf) Where.

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