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

Purchasing Power Parity

The Interest Rate Parity

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 = 1.2017 $/ x 3.45 = $4.1676

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

the general price level in country B

sa/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

Simplistic model Transportation costs Tariffs and taxes Consumption patterns differ Non-traded goods & services

Imperfect Markets Sticky prices Markets dont work well

Statistical difficulties Construction of price indexes Different goods Price index includes tradable and non tradable goods

Big Mac and PPP