Learning Outcomes
Purchasing Power Parity (PPP)
1. Interpretations of Purchasing Power Parity a. Absolute Form of PPP: It suggests that prices of the same basket of products in 2 different countries should be equal when measure in a common currency. Realistically, the existence of transportation costs, tariffs and quotas prevent absolute PPP b. Relative Form of PPP: State that the rate of change in the prices of the baskets should be somewhat similar when measured in a common currency, as long as transportation costs and trade barriers are unchanged
B. Discuss the International Fisher effect (IFE) theory and its implications for exchange rate changes
C. Compare the PPP theory, the IFE theory, and the theory of interest rate parity (IRP), which was introduced in the previous chapter
Relative PPP
Derivation of PPP
ef = [(1+Ih)/(1+If)] – 1
ef = % change in foreign currency
Ih = Inflation of home country
If = Inflation of foreign country
The formula reflects the relationship between relative inflation rates and exchange rates according to PPP
If Ih > If, ef is positive, foreign currency will appreciate
PPP
Relative PPP
2. Rationale behind Purchasing Power Parity Theory: Exchange rate adjustment is necessary for the
relative purchasing power to be the same whether buying products locally or from another country Appreciation/Depreciation of future exchange rate = Inflation differential Refer to e.g. in p.234
Movement
Confounding Effects
e f ( INF , INT , INC , GC , EXP ) where e percentage change in the spot rate INF change in the differenti al between U. S. inflation and the foreign country' s inflation INT change in the differenti al between th e U.S. interest rate and the foreign country' s interest rate INC change in the differenti al between th e U.S. income level and the foreign country' s income level GC change in government controls EXP change in expectatio ns of future exchange rates
Commodities
Graphic Analysis of PPP
5. Graphic Analysis: a. PPP Line b. Purchasing Power Disparity
Graphic
PPP Line
Triangular Arbitrage
Purchasing Power Disparity
If Ih < If, ef is negative, foreign currency will
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depreciate
Derivation
Derivation of PPP
4. Using PPP to Estimate Exchange Rate Effects: Refer to p.235-236 for e.g. a. Using a Simplified PPP Relationship, whereby, ef = Ih – If b. Exhibit 8.1 p.237 summarizes PPP
Relationship Between Inflation, Interest Rates and Exchange Rates
Learning Outcomes
Learning outcomes for Lecture 7:
A. Discuss the purchasing power parity (PPP) theory and its implications for exchange rate changes