Exchange Rate

vs.
Purchasing Power Parity
Exchange Rate
Factors of Exchange Rate

1. Interest Rate
2. Inflation
3. State of Politics
4. Economy in each country
Exchange Rate

 
 
Purchasing Power Parity

Purchasing Power - the amount of goods and services

you can buy with a certain amount of money.

PPP is an economic theory that compares

different countries currencies through a "basket
of goods" approach
purchasing Power Parity

 LAW OF ONE PRICE

1 good should have the same price of an identical
good in another country when converted into
different currencies.

Refers to the situation where your income has

the same purchasing power in all countries.
Purchasing Power Parity

 PPP rates are often difficult to determine because:

1. Differences in purchasing habits among citizens in

different countries.
2. Unequal quality of goods in those countries.
3. Differences of each countries economy.
Absolute Purchasing Power Parity

A commodity costs the same regardless of

what currency is used to purchase it or where
it is selling.
 
 If the price of apples in NY is $4 per bushel and £2.40
per bushel in London
 Beer costs £2 in London, exchange rate is £.60 per
dollar
Relative Purchasing Power Parity

 Determines the change in exchange rates over time.

 Change in exchange rates determined by relative
change in inflation rates.
 
 Apple in Britain= £2
 Apple in US= $4
 Suppose £.50=$1, if inflation rate is expected to be 10% in Britain and
0% in the US.

 If the inflation rate is not zero, then the relative inflation rate
determines the charge in exchange rates.
-suppose US inflation rate is 4%, from previous example the relative
inflation rate is 10%- 4%=6%.
 Example- consider the previous example and assume
that the inflation rates in Britain and US are expected
to remain the same for 3 years.