Topic 4

Purchasing Power Parity (PPP)

Dr. Xu Wang
Lecturer in Finance
Faculty of Business and Law
University of Northampton
Lecture outline

• Purchasing Power Parity (PPP)

• Absolute Form of PPP
• Relative Form of PPP
Learning objectives

• Explain the purchasing power parity (PPP) theory and its implications
for exchange rate changes.
• Apply PPP to determine exchange rates
• List reasons that why PPP does not hold
Lecture outline

• Purchasing Power Parity (PPP)

• Absolute Form of PPP
• Relative Form of PPP
Absolute Form of PPP

• Absolute Form of PPP: Without international barriers, consumers shift

their demand to wherever prices are lower. Prices of the same basket
of products in two different countries should be equal when
measured in common currency.
Lecture outline

• Purchasing Power Parity (PPP)

• Absolute Form of PPP
• Relative Form of PPP
Relative Form of PPP (1)

• Relative Form of PPP: Due to market imperfections, prices of the

same basket of products in different countries will not necessarily be
the same, but the rate of change in prices should be similar when
measured in common currency
Relative Form of PPP (2)

Rational Behind Relative PPP Theory

• Exchange rate adjustment is necessary for the relative purchasing
power to be the same whether buying products locally or from
another country.
• If the purchasing power is not equal, consumers will shift purchases
to wherever products are cheaper until the purchasing power is
equal.
Relative Form of PPP(3)

Derivation of Purchasing Power Parity

Relationship between relative inflation rates (I) and the exchange rate
(e).

𝑡 0 1 + 𝐼ℎ 1 + 𝐼ℎ
𝐸ℎ/𝑓 ÷ 𝐸ℎ/𝑓 = 1 + 𝑒ℎ/𝑓 =
1 + 𝐼𝑓 1 + 𝐼𝑓
where
ef represents the percentage change in the value of the foreign
currency.
Ih is the inflation rate in the home country
If is the inflation rate in the foreign country
Relative Form of PPP – an example

Assume that the spot exchange rate of the British pound is $1.73. How
will this spot rate adjust according to PPP if the United Kingdom
experiences an inflation rate of 7 percent while the United States
experiences an inflation rate of 2 percent?
Relative Form of PPP (4)

Using PPP to Estimate Exchange Rate Effects

• The relative form of PPP can be used to estimate how an exchange rate
will change in response to differential inflation rates between countries.
• International trade is the mechanism by which the inflation differential
affects the exchange rate according to this theory
• Using a simplified PPP relationship:
e f  Ih − I f
• The percentage change in the exchange rate should be approximately
equal to the difference in inflation rates between the two countries.
Summary of Purchasing
Power Parity
Relative Form of PPP (5) - Why PPP Does Not Hold
Confounding effects
• A change in a country’s spot rate is driven by more than the
inflation differential between two countries:

• Since the exchange rate movement is not driven solely by ΔINF, the
relationship between the inflation differential and exchange rate
movement cannot be as simple as the PPP theory suggests.
Relative Form of PPP (6) - Why PPP Does Not Hold

No Substitutes for Traded Goods

• If substitute goods are not available domestically, consumers may not
stop buying imported goods.
Impact of Inflation on an MNC’s Value