PURCHASING POWER PARITY THEORY(PPP)

Purchasing Power Parity (PPP) is the economic theory that price levels between two countries
should be equivalent to one another after exchange-rate adjustment. The basis of this theory is
the law of one price, where the cost of an identical good should be the same around the world.
Based on the theory, if there is a large difference in price between two countries for the same
product after exchange rate adjustment, an arbitrage opportunity is created, because the product
can be obtained from the country that sells it for the lowest price.

PPP states that there is a link between prices in two countries and the exchange rate between the
currencies of both the countries.

Absolute PPP Theory:

The Law of one price states that an identical product should have the same price in two
countries. According to the PPP theory, the law of one price should operate for an identical
commodity sold in two countries. Therefore, the price of a product in country X and the price of
an identical product in country Y (in Y’s currency) should be such that, the ratio of the prices is
the exchange rate between the currencies of the two countries.

When PX is the price of a product in country X, PY is the price of an identical product in

country Y, X is the currency of country X; and Y is the currency of country Y, then:

When the Law of one price is violated, arbitrage opportunities arise—commodities that sell at a
lower price in country X will be transported to country Y and sold at the higher price prevailing
there. This will continue till prices in both countries equalize.

Simply put, what this means is that a bundle of goods should ideally cost the same in Canada and
the United States. However, if it doesn’t happen then we say that purchasing power parity does
not exist between the two currencies.

Lets look at an example:

Suppose that one U.S. Dollar (USD) is currently selling for fifty Indian Rupees(INR).So the
exchange rate is $1=50

•In the United States, wooden cricket bats sell for $40 while in India, they sell for 750 Rupees.

Since 1 USD = 50 INR, the bat which costs $40 USD in U.S costs only 15 USD if we buy it in
India.

Clearly there’s an advantage of buying the bat in India, so consumers would be happier to buy
the bat in India.

If consumers decide to do this, we should expect to see three things happen:

1.American consumers’ demand for Indian Rupees would increase which will cause the Indian
Rupee to become more expensive.

2.The demand for cricket bats sold in the United States would decrease and hence its prices
would tend to decrease.

3.The increase in demand for cricket bats in India would make them more expensive.

4.Thus the prices in the US and India would start moving towards an equilibrium.

RELATIVE VERSION OF PPP THEORY

When the inflation rate is higher in country X than in country Y, the price of goods in X will
increase more than the price of goods in Y. Since the Law of one price states that an identical
product should have the same price in both countries, X’s currency will depreciate with respect
to Y’s currency. The rate of depreciation is equal to the inflation differential. Therefore, the
relative version of PPP states that there is a link between the expected exchange rate E(S n) and
expected inflation rates (I) in two countries.

According to relative PPP, price changes due to differences in inflation are the cause and
exchange rate changes are the effect.Since the future price of a commodity is affected by the
expected inflation rate, the prices of a commodity in country X and in country Y are affected by
the expected inflation rates in the two countries.

The relative version of PPP is as follows:

Where 'e' represents the rate of change in the exchange rate and 'π1' and 'π2'represent the rates of
inflation for country 1 and country 2, respectively.

For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC is
5%, then ABC's currency should appreciate 4.76% against that of XYZ.

INTERNATIONAL FISHER EFFECT

The international Fisher effect (sometimes referred to as Fisher's open hypothesis) is a

hypothesis in international finance that suggests differences in nominal interest ratesreflect
expected changes in the spot exchange rate between countries.Nominal Interest Rates varies
directly with expected inflation rates. The hypothesis specifically states that a spot exchange rate
is expected to change equally in the opposite direction of the interest rate differential; thus,
the currency of the country with the higher nominal interest rate is expected to depreciate against
the currency of the country with the lower nominal interest rate, as higher nominal interest rates
reflect an expectation of inflation.

The International Fisher Effect (IFE) theory suggests that the exchange rate between two
countries should change by an amount similar to the difference between their nominal interest
rates. If the nominal rate in one country is lower than another, the currency of the country with
the lower nominal rate should appreciate against the higher rate country by the same amount.

The formula for IFE is as follows:

Where 'e' represents the rate of change in the exchange rate and 'i1' and 'i2'represent the rates of
inflation for country 1 and country 2, respectively.

Balance of Payments Theory

A country's balance of payments is comprised of two segments - the current account and
the capital account - which measure the inflows and outflows of goods and capital for a country.
The balance of payments theory looks at the current account, which is the account dealing with
trade of tangible goods, to get an idea of exchange-rate directions.

If a country is running a large current account surplus or deficit, it is a sign that a country's
exchange rate is out of equilibrium. To bring the current account back into equilibrium, the
exchange rate will need to adjust over time. If a country is running a large deficit (more imports
than exports), the domestic currency will depreciate. On the other hand, a surplus would lead to
currency appreciation.
The balance of payments identity is found by:

Where BCA represents the current account balance; BKA represents the capital account
balance; and BRA represents the reserves account balance.