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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 .

how? Does interest rate affect exchange rate? If it does.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? How can we arrive at a more proper and actual exchange rate? .

Theories of exchange rate determination Purchasing Power Parity The Interest Rate Parity International Fisher Effect .

LAW OF ONE PRICE . • If the law of one price holds for all goods and services.Purchasing Power Parity • The PPP theory focuses on the inflation – exchange rate relationships. we can obtain the theory of PPP.

arbitrage opportunities exist Assumes that there will be no shipping costs. Relates to a particular commodity. asset etc..etc. security. taxes….Law Of One Price • Law of one price states “ In an efficient all • identical goods must have only one price” Identical goods should sell at identical prices in different markets If not. tariffs. • • • .

S.1676 .S.45 € = $4.• Example Price of wheat in France (per bushel): P€ Price of wheat in U.15 S€/$ = 0. (per bushel): P$ S€/$ = spot exchange rate P€ = S€/$  P$ • Example: Price of wheat in France per bushel (p€) = 3. per bushel (p$) = $4.8313 (s$/€ = 1.2017 $/€ x 3.45 € Price of wheat in U.2028) Dollar equivalent price of wheat in France = s$/€ x p€ = 1.

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 .Historical back drop • A Swedish economist Gustav Cassel introduced the PPP theory in 1920s • Countries like Germany.

Absolute PPP Law of one price extended to a basket of goods • If the price of the basket in the U. the US dollar depreciates . rises relative to the price in Euros.S.

83215 €/$ Has the US dollar appreciated or depreciated? . over a period of three days May 21 : s€/$ = P€ / PUS = 1235.01 = 0.75 € / $1482.8338 €/$ May 24: s€/$ = 1235.S.75 € / $1485.Have a look If the price of the basket in the U.07 = 0. rises relative to the price in Euros.

Mathematically . Absolute PPP postulates that sa/b = Pa / Pb Pa Pb is the general price level in country A is the general price level in country B sa/b is the exchange rate between currency of country A and currency of country B .

prices of similar products of two countries should be equal when measured in a common currency as per the absolute version of PPP theory .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.

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 .