Relative Purchasing Power

Parity
International Finance
Learning Objectives

• Analyze how future spot exchange rates vary from current spot rates
based on inflation rate differences between countries
• Assess the implications of real exchange rate changes for international
trade and investment

2
Inflation Rates and Future Spot Rates

3
Inflation and Exchange Rates

• Relative Purchasing Power Parity (RPPP) relates the (spot) exchange rate
at some future point in time to the current exchange rate using price
changes—inflation rates—in the corresponding countries
• RPPP derives from applying a weaker version of APPP now and at some
future point in time
• We know, APPP may not be particularly helpful in determining what the
(spot) exchange rate is today
• …….but RPPP may, nevertheless, be very useful in determining the change
in the exchange rate

RPPP can hold even if APPP does not

4
• Approach I: Suppose that APPP holds proportionally over time:

Pt $1  k  Pt £1  St$/1£

Pt $  k  Pt £  St$ / £

– Dividing, we get
Pt $1 k Pt £1 St$/1£
$
  £  $/£
Pt k Pt St

Pt$1
– Rearranging, we get $
$ / £ Pt
S $/£
t 1 S t Pt£1
Pt£

– Or, (1   $ )
S $/ £
t 1 S t
$/£

(1   £ )

 
Where 5
• Approach II: Suppose that internal and external purchasing power
remain proportional over time (c=1/k)

 1 1 1  1 1 1
$
=𝑐 × $ / £ × £ $
=𝑐 × $ / £ × £
𝑃𝑡 𝑆𝑡 𝑃𝑡 𝑃 𝑡+1 𝑆 𝑡 +1 𝑃𝑡 +1
Goods Pounds per Goods Pounds per
per dollar dollar x goods per dollar dollar x goods
in US per pound in US per pound

= Goods per = Goods per

dollar in UK dollar in UK

Time = t Time = t Time=t+1 Time=t+1

6
• With either motivation, we can represent RPPP mathematically:

  1+ 𝝅 $ $
 $𝟏 /$£/ £ $/£   1+ 𝝅 £ £
 £𝟏 /£$/ $ £/$
𝑺 =𝑺 1+ 𝝅£ 𝟎 $/£ 𝑺 =𝑺 1+ 𝝅$ 𝟎 £/$
𝑺 =𝑺 1+ 𝝅 £
𝟏 𝟎 𝑺 =𝑺 1+ 𝝅 $
𝟏 𝟎
1+ 𝝅 1+ 𝝅

• Where the inflation rate in US dollars is p$, the inflation rate in yen is p£,
and the spot exchange rate is S0 now and S1 in one period (currency
notation suppressed)

7
• Further, we can make the following approximate representation of RPPP:

£/$ £/$
 𝑺 $ /£ − 𝑺 $ / £  𝑺 𝟏 − 𝑺 𝟎
𝟏𝟏 𝟎 𝟎 $ £ 𝟏 𝟎 £ $
$/£
=𝝅 − 𝝅 £/$
=𝝅 − 𝝅
𝑺 𝟎 𝑺 𝟎

Note the left-hand side of the approximate versions of RPPP is

appreciation of the yen and dollar, respectively:

$ /£ $/£ £/$ £/$

 𝑺 𝟏 − 𝑺 𝟎  𝑺 𝟏 − 𝑺 𝟎
𝟏 𝟎 𝟏 𝟎
$/£
= 𝑨𝒑𝒑𝒓 £ £/$
= 𝑨𝒑𝒑𝒓 $
𝑺 𝟎 𝑺 𝟎

8
Discussion: RPPP says appreciation of the foreign currency (£) equals
the excess inflation in the domestic ($) vs. the foreign currency (£) …
what’s the intuition?

S1$/£  S 0$/£
  $
  £

S 0$/£
Appreciation of £

Can you draw a parallel to the quantity theory of money?

 
Appreciation of £

9
• Example: Suppose the exchange rate at the start of the year is $1.50/£ and
that prices of US goods rise 4 percent and prices of UK goods rise by 2
percent by the end of the year
– According to RPPP, what should be the exchange rate at the end of the year?

  $/£ $/£ 1+ 𝜋 $
𝑆 1 =𝑆 0 £
1+ 𝜋

1.04
¿  $ 1 .50/ £
1.02

¿  $ 1.5294 / £

10
 S1$/£  S 0$/£
  $  £
S 0$/£

• Or, approximately,

S1$/£  S 0$/£ 1.5294  1.50

  2%  $   £  4%  2%  2%
S 0$/£ 1.50

Here, the pound appreciated approximately 2% relative to the dollar

because the dollar suffered 2% higher inflation than the pound

11
• Example: Suppose the exchange rate at the start of the year is $1.50/£ and
that prices of US goods rise 2 percent and prices of UK goods rise by 3
percent by the end of the year
– According to RPPP, what should be the exchange rate at the end of the year?

  $/£ $/£ 1+ 𝜋 $
𝑆 1 =𝑆 0 £
1+ 𝜋

1.02
¿  $ 1 .50/ £
1.03

¿  $ 1 .4854 /£

12
 S1$/£  S 0$/£
  $  £
S 0$/£

• Or, approximately,

S1$/£  S 0$/£ 1.4854  1.50

  1%  $   £  2%  3%  1%
S 0$/£ 1.50

Here, the pound depreciated approximately 1% relative to the dollar

because the pound suffered 1% higher inflation than the dollar

13
• IMPORTANT NOTE: SO FAR WE’VE ASSUMED WHOLE ONE-YEAR PERIODS
– Periods may be other than whole years
– Further, inflation rates are usually expressed in annualized (APR) terms
– So, adjustments may be necessary for consistency

Note: in this course, we’ll always assume a 360-day year

14
Convert APRs (per year) to Periodic Inflation Rates

  𝟏+ 𝝅 × 𝒅𝒂𝒚𝒔
( )
$

$/£ $ /£ 𝟑𝟔𝟎
𝑺 𝒅𝒂𝒚𝒔 =𝑺 𝟎
𝟏+ 𝝅 × 𝒅𝒂𝒚𝒔
( )
£
𝟑𝟔𝟎

Leave Inflation Rates as APRs and Annualize Appreciation

 𝑺 $ /£ − 𝑺 $ /£
𝒅𝒂𝒚𝒔 𝟎 𝟑𝟔𝟎 $ £ This remains an
$/£
× =𝝅 − 𝝅 approximate relation
𝑺 $𝟎 / £ 𝒅𝒂𝒚𝒔
15
More On The Real Exchange Rate

• Example (again): Suppose the US price level is $15,000 per consumption

bundle, and the British price level is £12,000 per consumption bundle. If
the nominal exchange rate is $1.30/£, then the real exchange rate is:

  $ 1.30
(
𝑅 $/ £ =
£ ) £ 12,000
=1.04
$ 15,000

– This means 1.04 US “bundles” may be exchanged for 1 UK “bundle”—

currencies have been removed from the equations and the exchange is in real
terms
– Alternatively, 1.04 dollars are required (after conversion to pounds) to
purchase what just 1.00 dollar can purchase in the US—UK goods are 4%
more expensive to Americans with dollars 16
• Example (cont.): Now, suppose over the next year there is 4%
inflation in the dollar and 8% inflation in the pound and RPPP holds,
what is the new real exchange rate?
(1   $
)
Pt 1  Pt (1   )
$ $ $
P £
t 1  P £
(1   £
) S $ /
t 1
£
 S $
t
/ £
t
(1   £ )
 $15,000(1.04)  £12,000(1.08)
1.04
 $15,600  £12,960  $ 1 . 30 / £
1.08
 $1.2519 / £

S t$/1£ Pt £1
R $/£
t 1 
Pt $1
($1.2519 / £) (£12,960)
  1.04
$15,600

No change!
17
When RPPP holds, the real exchange rate does not change!

18
Discussion:

Today the dollars needed to buy 1 apple in the US can (after conversion) buy 2 apples
 𝑅is$/ £ ?
in the UK, does APPP hold? What
No!
 𝑅 $/ £ =1/ 2

One year later, assuming RPPP holds, how many apples can the dollars needed to buy
1 apple in the US (that will be more than last year because of inflation) buy in the
UK?
2 Apples

19
Discussion:
Suppose RPPP holds, inflation in the US $ is 5%, and inflation in the £ is 2%.
If you are saving for a vacation in the UK in one year and your research
shows you will need $100 per day today , how much will you have to have
saved per day in one year?

20
• When RPPP holds, dollar inflation at home equals dollar inflation (after
conversion) abroad!!
• To see this, let’s recall the real rate of exchange does not change when
RPPP holds
$ /£ £ $, 𝑈𝐾 𝐺𝑜𝑜𝑑
 $/ £ 𝑆𝑡 𝑃 𝑡   𝑃 𝑡
𝑅𝑡 =𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 = $ ¿ $, 𝑈 𝑆 𝐺𝑜𝑜𝑑
𝑃𝑡 𝑃𝑡

– So, if the price of US goods rises by 5% (denominator), the price of UK goods in

$ must also rise by 5%
 US
$
  UK
$

21
When RPPP holds, domestic inflation in home currency—through
exchange rate adjustments—equals inflation abroad in home
currency

22
 S t$ / £ Pt £
R
t
$/£

Pt $
• So if RPPP holds, real appreciation is zero

$/ £ $/£
𝑅
 
𝑡 +1 =𝑅 𝑡

• But, we knew that from the start. Recall Approach I:

Pt $  k  Pt £  St$ / £ All t

1 St$ / £ Pt £
  Rt
$/£
k Pt $

Constant 23
Therefore, changes in the real exchange rate must imply a
violation of RPPP!

24
 (1   $ )
S $/£
S $/ £
Pt$1  Pt$ (1   $ ) Pt£1  Pt£ (1   £ ) t 1 t
(1   £ )
 $15,000(1.04)  £12,000(1.08) 1.04
 $1.30 / £
 $15,600  £12,960 1.08
 $1.2519 / £

• Example (cont.): Let the inflation rates in both countries remain

unchanged, but now suppose the pound’s nominal exchange rate does
not depreciate by the percentage implied by RPPP, from $1.30/£ to
$1.2519/£ :

 𝑆 $ /£ − 𝑆 $ / £ $ 1.2519/ £ − $ 1.30 / £
𝑡+1 𝑡
$/£
= =− 3.704 %
𝑆𝑡 $ 1.30/ £

Instead, depreciates by less, 2% to:

  (

25
   $/ £ 𝑆 $ / £ 𝑃£
𝑅 = $
𝑃

• Example (cont.): The new real exchange rate is:

Pt$1  $15,600

Pt £1  £12,960

𝑆  $ / £ =$ 1.2740 /£

($1.2740 / £) £12,960
Rt$/1£   1.0584  1.04
$15,600

So, the pound experiences real appreciation despite nominal

depreciation because nominally the pound did not lose value consistently
with its higher inflation rate, that is, consistently with RPPP

26
When RPPP is violated, there can be real appreciation in a currency
despite nominal depreciation and vice versa!!

27
• Indeed, when RPPP does NOT hold, and the nominal (bank) exchange
rate changes at a different rate, the real exchange rate does indeed
change
Banks choose

  $/ £ 1+% 𝐴𝑝𝑝𝑟 £
𝑅𝑡 +1 =𝑅 $/£
𝑡 [ 1+% 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £ ]
– Real appreciation results when nominal appreciation exceeds RPPP
appreciation
– Real appreciation also results when nominal depreciation falls short of (less
negative appreciation than) RPPP depreciation 28
• In the last example, the new real exchange rate is:

$
  1+ % 𝐴𝑝𝑝𝑟 £
𝑅 =𝑅
$/ £
𝑡 +1
£
𝑡 [ 1+ % 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £ ] Nominal
depreciation
was slower than
that RPPP
  (1− 0.02) requires!
𝑅𝑡$/+1£ =1.04
[ (1 −0.03704 ) ]
¿  1.0584>1.04

29
Optional:   𝑆 $1 / € 𝑃£1  𝑆 $0 /£ (1+% 𝐴𝑝𝑝𝑟 £) 𝑃£0 (1+ 𝜋 £ )
$/ £
𝑅 1 = $
¿ $ $
𝑃1 𝑃0 (1+ 𝜋 )

  $/ £ (1+% 𝐴𝑝𝑝𝑟 £ )(1+ 𝜋 £)

¿𝑅 0 $
(1+ 𝜋 )

$/ £ (1+% 𝐴𝑝𝑝𝑟 £ )
¿  𝑅0 $
(1+ 𝜋 )
£
(1+𝜋 )

$ /£
  𝑆1 1+ 𝜋
$
𝐵𝑢𝑡 , 𝑅𝑃𝑃𝑃 𝑖𝑚𝑝𝑙𝑖𝑒𝑠 : $ /£ = £
𝑆0 1+ 𝜋
$
 1+ 𝜋 ❑
1+%
  𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £=¿ £
1+ 𝜋 ❑
  1+% 𝐴𝑝𝑝𝑟 £
𝑅1$/ £ =𝑅 $0 / £
[ 1+% 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £ ] 30
 In the last example, as the pound appreciates in real terms, what is
the impact on trade?

British exporters become less British importers become more

competitive competitive
• British exporters now have still more • British importers have even less
expensive products to sell abroad expensive US products to sell at home

• It now takes $1.0584 for an American • It now takes 1/1.0584 = 0.9448£ for a
consumer to purchase in/from Britain British consumer to purchase in/from the
what $1 could buy at home US what £1 could buy at home

• A year ago it took only $1.04 • A year ago it cost 1/1.04 = 0.9615£

  £ /$ 1
𝑅 = $/ £
𝑅
31
Violations of RPPP, through the change in the real exchange rate,
can reverse prior preferences for trade and cross-border
investment!

32
• Example:
  Suppose we own and manage a restaurant in Miami. Last year,
we priced both California Cabernet Sauvignon and French Bordeaux wines
for our wine list. At that time, we were indifferent (both cost the same in
US dollars, APPP holds, or =1).
– One year later, we learn that the euro has depreciated 10 percent relative to
the dollar. Can we conclude that we now have a strict preference for French
wine?
No way!
The euro may have depreciated in the currency markets in response to higher
euro inflation—higher euro prices….and don’t forget US prices have likely
changed too
We need to know:
$/€ €
€ $/€  $/ € 𝑆 𝑃
𝑃
  1 𝑆1 𝑣𝑠 $
  . 𝑃1 OR 𝑅 = $
𝑃 33
• Let’s make a formal equation for % appreciation according to RPPP:

  𝑆 $1 / €
1+ 𝜋
$
𝑅𝑃𝑃𝑃 𝑖𝑚𝑝𝑙𝑖𝑒𝑠 : $ / € =
𝑆0 1+ 𝜋 €

  1+𝜋 $
1+% 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 € = €
1+ 𝜋

34
 $/€
  𝑆1 1+ 𝜋
$ $
 1+ 𝜋 ❑ 1+2%
𝑅𝑃𝑃𝑃 𝑖𝑚𝑝𝑙𝑖𝑒𝑠 : $ / € =
𝑆0 1+ 𝜋
€ 1+%
  𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 €=¿
1+ 𝜋
¿
€ 1+15%
=0.8870=1−11.30% 
❑

– Suppose euro inflation was 15 % and US dollar inflation was 2%

– What’s the new R?

  1+% 𝐴𝑝𝑝𝑟 €
𝑅1$/ € =𝑅 $0 / €
[ 1+% 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 € ]
  (1− 0.10)
¿ 1.00
[ (0 .8870) ]
1−
  11.30%
¿  1.0147>1.00

– Our conclusion is the opposite: we now have a strict preference for the
California red because the French wine is now 1.47 percent more expensive!
35
Summary

• The relative theory of PPP states that the (nominal) appreciation of one
currency relative to another should be proportional to the difference
between the countries’ inflation rates
• The real exchange rate takes into account the nominal exchange rate and
the relative price levels in two countries, and expresses the exchange rate
in terms of real goods
• It is the real exchange rate that has implications for international trade
and direct investment
• Changes in the real exchange rate, not the nominal exchange rate, that
influence international trade and direct investment

36
Appendix: Change in Real Rate
𝑆𝑡$/+1£ 𝑆 $𝑡 +1
/£
𝑆𝑡$ /£ (1+% 𝐴𝑝𝑝𝑟 £)
 
𝑅
$/ £
𝑡 +1 = $/£ = $ ¿  $ $
𝑆 𝐴𝑃𝑃𝑃 ,𝑡 +1 𝑃𝑡 +1 𝑃𝑡 (1+𝜋 )
£
𝑃𝑡 +1 𝑃𝑡£ (1+𝜋 £ )

𝑆𝑡$ /£ (1+% 𝐴𝑝𝑝𝑟 £ )

¿  $ $
𝑃𝑡 (1+𝜋 )
𝑃𝑡£ (1+𝜋 £ )

(1+% 𝐴𝑝𝑝𝑟 £ )
¿  𝑅𝑡
$/ £

(1+ 𝜋 $ )
£
(1+𝜋 )

$
  1+ 𝜋❑
  £ 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £
¿1+%
1+ 𝜋❑
(1+% 𝐴𝑝𝑝𝑟 £ )
¿  𝑅𝑡
$/ £

(1+% 𝑅𝑃𝑃𝑃 𝐴𝑝𝑝𝑟 £ )

37
Discussion: In a fixed exchange rate regime, if inflation rates differ, will the
higher inflation country’s currency experience real appreciation or real
depreciation?

  $/ 𝐹 𝑆$/𝐹 𝑃𝐹 $/𝐹 𝑃
𝐹
𝑅 = $
=𝑆 $
𝑃 𝑃

Recalling our discussion of the Impossibility Trinity, what must the central
bank also impose to both:
1. hold the exchange rate of currency F fixed vs. the dollar and
2. target an inflation rate in F that differs from inflation in the dollar?

38
Appendix: RPPP and %Change
in Purchasing Power
• Assuming purchasing power proportionality over time and taking the ratio
of purchasing power at t+1 to that at t in the US and Japan, we see:
Purchasing Power of $ in US at Purchasing Power of $ in Japan
t+1 relative to t at t+1 relative to t

 1   1 1
$ 𝑐 $/¥ × ¥
𝑃 𝑡+1 𝑆𝑡 +1 𝑃𝑡 +1
=
 1   1 1
$ 𝑐 $/¥ × ¥
𝑃𝑡 𝑆𝑡 𝑃𝑡

1 + %Change in Purchasing 1 + %Change in Purchasing

Power of $ in US
=
Power of $ in Japan

%Change in Purchasing Power %Change in Purchasing Power

of $ in US
=
of $ in Japan 39
• Purchasing power proportionality over time also implies RPPP:

 1   1 1
×
$
𝑃 𝑡+1  1 𝑆 𝑡+1 𝑃 ¥𝑡+1
$ /¥  𝑆 $ /¥ 1
𝑡
= $ = ¥
  1 (1 +𝜋 )   1 1 𝑆
$ /¥
(1 +𝜋 )
$ $ /¥
× ¥ 𝑡+1
𝑃𝑡 𝑆𝑡 𝑃𝑡
=

  $/¥ $ /¥ 1+ 𝜋 $
𝑆 𝑡 +1 =𝑆
𝑡
1+ 𝜋 ¥

40
 1 1
 1 𝑐  $ / ¥ × ¥
𝑃 $𝑡+1 𝑆𝑡 +1 𝑃𝑡 +1
=
 1 1 1
$
𝑐  $ / ¥ × ¥
𝑃𝑡 𝑆𝑡 𝑃𝑡

• Or, inverting the proportionality equation and dividing the resulting

equality at t+1 by that at t, we see:

 𝑃 $
𝑡 +1
𝑆  $𝑡 +1
/¥
× 𝑃¥𝑡+1
 𝑃 $
𝑡
= 𝑆  $𝑡 / ¥ × 𝑃¥𝑡
$
𝑃
  𝑡+1  𝐷𝑜𝑙𝑙𝑎𝑟 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑖𝑛 𝐽𝑎𝑝𝑎𝑛𝑡 +1
=
𝑃𝑡
$ 𝐷𝑜𝑙𝑙𝑎𝑟 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑖𝑛 𝐽𝑎𝑝𝑎𝑛 𝑡

  1 +𝜋 $  1+𝜋 $
𝑈𝑆 = 𝐽𝑎𝑝𝑎𝑛

When RPPP holds, dollar inflation at home equals dollar inflation (after
conversion) abroad 41