Purchasing Power Parity (PPP)

when a countrys inflation rate rises, the demand for its currency declines as its exports decline (due to its higher prices). In addition, consumers and firms in that country tend to increase their importing. Both of these forces place downward pressure on the highinflation countrys currency. Inflation rates often vary among countries, causing international trade patterns and exchange rates to adjust accordingly. ne of the most popular and controversial theories in international finance is the purchasing power parity (PPP) theory, which attempts to !uantify the inflation"exchange rate relationship.

Interpretation of Purchasing Power Parity

#$solute %orm of &&&' without international $arriers, consumers shift their demand to wherever prices are lower. &rices of the same $as(et of products in two different countries should $e e!ual when measured in common currency. )elative %orm of &&&' *ue to mar(et imperfections, prices of the same $as(et of products in different countries will not necessarily $e the same when measured in a common currency. +owever, the rate of change in prices should $e somewhat similar when measured in common currency as long as transportation costs and trade $arriers are unchanged.

Relationship between relative inflation rates (I) and the exchange rate (e).
ef = 1+ Ih 1 1+ I f

,his formula reflects the relationship $etween relative inflation rates and the exchange rate according to &&&. -otice that if Ih.If, ef should $e positive. ,his implies that the foreign currency will appreciate when the home countrys inflation exceeds the foreign countrys inflation. /onversely, if Ih0If, then ef should $e negative. ,his implies that the foreign currency will depreciate when the foreign countrys inflation exceeds the home countrys inflation. Simplified PPP relationship
e f I h I f

Summary of Purchasing Power Parity

Illustration of Purchasing Power Parity

,he diagonal line connecting all these points together is (nown as the purchasing power parity (&&&) line. &oint # represents the 2.3. (considered the home country) and British inflation rates were assumed to $e 4 and 5 percent, respectively, so that Ih- If 678. )ecall that this led to the anticipated appreciation in the British pound of 7 percent, as illustrated $y point #. &oint B reflects a situation in which the inflation rate in the 2nited 9ingdom exceeds the inflation rate in the 2nited 3tates $y 5 percent, so that Ih -If 658. ,his leads to anticipated depreciation of the British pound $y 5 percent, as illustrated $y point B. If the exchange rate does respond to inflation differentials as &&& theory suggests, the actual points should lie on or close to the &&& line.

Identifying isparity in Purchasing Power

#ssume an initial e!uili$rium situation, then a change in the inflation rates of the two countries. If the exchange rate does not move as &&& theory suggests, there is a disparity in the purchasing power of the two countries. &oint / represents a situation where home inflation (Ih) exceeds foreign inflation (If) $y 7 percent. ;et, the foreign currency appreciated $y only 1 percent in response to this inflation differential. /onse!uently, purchasing power disparity exists. +ome country consumers purchasing power for foreign goods has $ecome more favora$le relative to their purchasing power for the home countrys goods. ,he &&& theory suggests that such a disparity in purchasing power should exist only in the short run. ver time, as the home country consumers ta(e advantage of the disparity $y purchasing more foreign goods, upward pressure on the foreign currencys value will cause point / to move toward the &&& line. #ll points to the left of (or a$ove) the &&& line represent more favora$le purchasing power for foreign goods than for home goods. &oint * in represents a situation where home inflation is < percent $elow foreign inflation. ;et, the foreign currency has depreciated $y only : percent. #gain, purchasing power disparity exists. ,he purchasing power for foreign goods has $ecome less favora$le relative to the purchasing power for the home countrys goods. ,he &&& theory suggests that the foreign currency in this example should have depreciated $y < percent to fully offset the < percent inflation differential. 3ince the foreign currency did not wea(en to this extent, the home country consumers may cease purchasing foreign goods, causing the foreign currency to wea(en to the extent anticipated $y &&& theory. If so, point * would move toward the &&& line. #ll points to the right of (or $elow) the &&& line represent more favora$le purchasing power for home country goods than for foreign goods.

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!esting the Purchasing Power Parity !heory "onceptual !ests of PPP# ne way to test the &&& theory is to choose two countries (say, the 2nited 3tates and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currencys value during several time periods. Statistical !est of PPP# # somewhat simplified statistical test of &&& can $e developed $y applying regression analysis to historical exchange rates and inflation differentials Results of !ests of PPP# when an exchange rate deviated far from the value that would $e expected according to &&&, it moved toward that value. #lthough the relationship $etween inflation differentials and exchange rates is not perfect even in the long run, it supports the use of inflation differentials to forecast long-run movements in exchange rates. !ests of PPP for $ach "urrency . /omparison of the actual values of foreign currencies with the value that should exist under conditions of purchasing power parity. %imitation of PPP !ests' # limitation in testing &&& theory is that the results will vary with the $ase period used. %or example, if 14=> is used as a $ase period, most su$se!uent periods will show a relatively overvalued dollar? $y contrast, if 14>7 is used, the dollar may appear undervalued in su$se!uent periods. ,he $ase period chosen should reflect an e!uili$rium position, since