PRESENTED BY VEERESH AND SANTHOSH.M

Purchasing Power Parity

INTRODUCTION

The concept of purchasing power parity allows one to estimate what the exchange

rate between two currencies would have to be in order for the exchange to be on

par with the purchasing power of the two countries' currencies. Using that PPP rate

for hypothetical currency conversions, a given amount of one currency thus has

the same purchasing power whether used directly to purchase a market basket of

goods or used to convert at the PPP rate to the other currency and then purchase

the market basket using that currency. Observed deviations of the exchange rate

from purchasing power parity are measured by deviations of the real exchange

rate from its PPP value of 1.

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

International Fisher Effect

The Interest Rate Parity

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 marketsIf not, arbitrage opportunities existAssumes that there will be no shipping costs, tariffs, taxes….etc.Relates to a particular commodity, security, asset etc..

Cont..

Example

Price of wheat in France (per bushel): P€

Price of wheat in U.S. (per bushel): P$

S€/$ = spot exchange rate

Example

Price of wheat in France per bushel (p€) = 3.45 € Price of wheat in U.S. per bushel (p$) = $4.15S€/$ = 0.8313 (s$/€ = 1.2028)

Dollar equivalent priceof wheat in France = s$/€ x p€

= 1.2028 $/€ x 3.45 € = $4.1496

P€ = S€/$ P$

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

TYPES OF PPP

Absolute PPP

Relative PPP

RELATIVE PPP : Relative purchasing power parity is an economic

theory which predicts a relationship between the inflation rates of two

countries over a specified period and the movement in the exchange

rate between their two currencies over the same period. It is a dynamic

version of the absolute PPP theory

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

ADVANTAGES OF PPP THEORY

Purchasing power parity is important for developing reasonably accurate economic statistics to compare the market conditions of different countries. For example, purchasing power parity is often used to equalize calculations of gross domestic product. Because purchasing power can vary from country to country, the statistic for GDP based on purchasing power parity is often different than nominal GDP -- GDP as described by currency exchange alone.

Have a look

If the price of the basket in the U.S. rises relativeto 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

Pa is the general price level in country A

Pb is the general price level in country B

sa/b is the exchange rate between currency of country A and

currency of country B

sa/b = Pa / Pb

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

don’t work well

Statistical difficultiesConstruction

of price indexes Different goods

Price index includes

tradable and non tradable

goods

LIMITATIONS OF PPP THEORY

The theory assumes that changes in price levels could bring about changes in exchange rates not vice versa, that is, changes in exchange rates cannot affect domestic price levels of the countries concerned.The calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.According to the theory, to calculate the new equilibrium rate one must know the base rate i.e., the old equilibrium rate. But it is difficult to ascertain the particular rate which actually prevailed between the currencies as the equilibrium rate.The exchange rate is directly related to the purchasing power of currencies of two countries

CONCLUSION

PPP exchange rates help to avoid misleading international comparisons

that can arise with the use of market exchange rates. For example,

suppose that two countries produce the same physical amounts of goods

as each other in each of two different years. Since market exchange rates

fluctuate substantially, when the GDP of one country measured in its own

currency is converted to the other country's currency using market

exchange rates, one country might be inferred to have higher real

GDP than the other country in one year but lower in the other; both of

these inferences would fail to reflect the reality of their relative levels of

production. But if one country's GDP is converted into the other country's

currency using PPP exchange rates instead of observed market exchange

rates, the false inference will not occur.

Thank you