Slide 15-1

Purchasing power parity & Exchange rate

PAK-Aims «. Macro Economics Project

Nauman Khalid (101303)

Introduction 
The theory of Purchasing Power Parity (PPP) explains

movements in the exchange rate between two countries¶ currencies by changes in the countries¶ price levels. 
In short, what this means is that a bundle of goods should

cost the same in Canada and the United States once you take the exchange rate into account.

Purchasing Power Parity & Base ball Bat
y Suppose that one U.S. Dollar (USD) is currently selling for

10 Pakistani rupees (PKR) on the exchange rate market. y In the United States, Same wooden baseball bats sell for 40(USD). y While in Pakistan they sell for 150 (PKR). Since 1 USD =10 (PKR), then the bat costs \$40 USD if we buy it in the U.S. but only 15 USD if we buy it in Pakistan. y Clearly there's an advantage to buying the bat in Pakistan, so consumers are much better off going to Pakistan to buy their bats.

If consumers decide to do this, we should expect to see three things happen:
y American consumers desire Pakistani Currency in order to buy baseball bats in Pakistan. So they go to an Exchange office and sell their American Dollars and buy Pakistani rupee at present rate. y This will cause the Pakistani rupee to become more valuable relative to the U.S. Dollar. y The demand for baseball bats selling in the United States decreases, so the price American retailers charge goes down. y The demand for baseball bats selling in Pakistan increases, so the price Pakistani retailers charge have value.

But...
y If the U.S. Dollar value declines to 1 USD = 8 (PKR) and the price of baseball bats in the United States goes down to \$30 each and the price of baseball bats in Pakistan goes up to 240 (PKR) each. y There we will have Purchasing Power Parity(PPP). Because of this consumer will pay \$30 in the United States for the baseball bat, or he can take his \$30, exchange it for 240 (PKR) and buy the same baseball bat in Pakistan and be no better off.

y Now if we will take another example:

Let, we comsider prices of BIG Mac in the world.  We take two countries China and United States. We will consider BIG Mac prices in these two countries.  A Big Mac in China costs 10.5 Yuan which at the current exchange rate of \$US1 = 7. 7431Yuan means that in China the Big Mac costs \$US1.356.

y To obtain this, divide the foreign currency price (10.5 Yuan),

by 7.7431, the number of foreign currency units to a unit of the currency in which we wish to obtain the price (\$US).
y As we know that in China BIG Mac Costs 10.5(Yuan),

So, 7.7431Yuan is equal to 1US\$
= \$US1.356 Note that in the United States, a Big Mac costs \$US3.10

y So a BIG Mac is cheaper in China, than in US currency in

the United States, at the existing exchange rate. y So the US. dollar is overvalued and the Chinese Yuan undervalued given the Big Mac prices.

y In order to obtain the PPP exchange rate, y Divide the BIG Mac price in China in Yuan, by the BIG Mac

price in the US. in US. currency. So,10.5/3.10 = 3.387 y This says, \$US1 should equal 3.387 Yuan for the Big Mac to be the same price in both countries, in either currency.
y So,if we multiply 3.10 with 3.387 it will be equal to 10.5 y And 10.50/3.387 = 3.10

y From this we can calculate the extent of the over or

undervaluation of a currency.
y PPP ± Actual Ex. Rate = % under or

Actual Ex. Rate

overvaluation

y So in this example,
3.387 ± 7.7431 7.7431 = - .5626 

=- 4.3561 7.7431

So the Chinese Yuan is undervalued 56.26% against the US. dollar.

Law of One Price & The Purchasing Power Parity theory
When we extend law of one price from one good to basket of goods, it becomes Purchasing Power Parity theory of exchange rate determination. The Purchasing Power Parity (PPP) theory is based on the assumption that real exchange rates are fixed. Thus it means that differences in the inflation rate in the two countries causes changes in nominal exchange rate between two countries. It states that whenever a country¶s price level is expected to fall relative to other country¶s price level, it¶s currency should appreciate relative to other country¶s currency.

Law of One Price and The Purchasing Power Parity theory
y Movements in exchange rates not completely consistent with PPP theory: y For differentiated products, law of one price does not hold, e.g. Kodak and Sony camera. y Not all goods and services (e.g. haircut, sandwich) are internationally traded. y Significant differences in prices of non-traded goods and services are not completely reflected in exchange rates. y The assumption of constant real exchange rate is not reasonable. There may be shifts in preferences for domestic or foreign goods and trade barriers.