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
International Fisher Effect

Purchasing Power Parity

The

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 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, arbitrage opportunities exist
Assumes 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

P = S/$ P$

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
= 1.2028 $/ x 3.45 = $4.1496

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 look
If the price of the basket in the U.S. rises relative
to 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

sa/b = Pa / Pb
Pa
Pb

is the general price level in country A

is

sa/b

the general price level in country B

is

the exchange rate between currency of country A

and currency of country B

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

Big Mac and PPP