Purchasing Power Parity

Theory

Unit-III
 Introduction

• The short run movements in the exchange rates are governed by asset market
conditions, the long run fluctuations in the exchange rates are anchored by goods
market conditions.
• The long run pattern is stated through trade balance (goods and services).
• The notion of PPP is one of the oldest concepts in economics.
• Purchasing Power Parity (PPP) theory is based on the ‘Law of One Price’.
• It says that exchange rates adjust to make goods and services cost the same
everywhere and thus it is an application of the law of one price.
 Example of PPP Theory: Law of One Price

• This analysis of exchange rates could be

depicted by following table.
• The table used the law of one price for
a single good, steel for foreign
exchange rate calculation.
• According to the law of one price, if
the yen price of steel increases by ten
percent and the dollar price of steel
remains constant, the yen will
depreciate by ten percent against the
dollar to ensure that price is the same
in both countries.
• Assume that the yen price of Japanese steel is 50,000 yen per ton and the dollar price of
American steel is $500 per ton.
• Therefore, the law of one price says that the exchange rate between the yen and the dollar is
100 yen per dollar (50,000/500=100) to ensure that price is the same in both countries.
• Suppose that the yen price of Japanese steel increases ten percent, to 55,000 yen per ton, and
the dollar price of American steel remains constant at $500 per ton.
• According to the law of one price, the exchange rate must increase to 110 yen per dollar
(55,000/500=110), a ten percent depreciation of the yen.
• Applying the law of one price to the prices of steel in Japan and the United States, we
conclude that if the Japanese price level increases by ten percent relative to the American
price level, the yen will depreciate by ten percent against the dollar.
• Goods denominated in the same currency should have identical price between markets after
adjusting for transportation costs.
• If a price difference exists between two markets, then arbitrage is possible. Traders would buy
products from the low-price market and sell it in the high-price market.
• Consequently, prices would converge to one price across all markets as traders shift the supply
of goods from the low-price market to the high-price market.
• The prices in the high-price market would fall while prices in the low-price market would rise
over time.
• Price could differ between markets because the price differential reflects the transportation
costs of the product from one market to another.
• Nevertheless, the PPP helps predict changes in exchange rates.
• The PPP refers to the idea that the same basket of goods should cost the same when
prices are measured in the same currency regardless of where it is located.
• So, for instance, suppose P$ is the price of a bundle of goods in the United States and
let P€ equal the price of an identical bundle in Italy (measured in Euros).
• If the two bundles are to have the same price, the following relationship must hold:
𝐄€/$ = 𝐏€/P$
• The theory of PPP says that the long-run equilibrium value of the actual exchange rate
will be E€/$.
• The PPP theory therefore predicts that a fall in a currency’s domestic purchasing power (as
indicated by an increase in the domestic price level) will be associated with a proportional
currency depreciation in the foreign exchange market.
• Symmetrically, PPP predicts that an increase in the currency’s domestic purchasing power will
be associated with a proportional currency appreciation.
• By re-arranging, we get: 𝐏$ = 𝐏€/𝐄€/$
• The left side of equation is the dollar price of the reference commodity basket in the US;
the right side is the dollar price of the reference basket when purchased in Euro area.
• Thus, PPP asserts that the price levels of all the countries are equal when measured in
terms of the same currency.
Example: PPP Theory
• Suppose the CPI for the US equals $755.3 while the CPI for Euro area is €1,241.2
Euros.
• Thus, the absolute PPP predicts the exchange rate should be 1.64 Euros per dollar.
• 𝐄€/$ = 𝐏€/ 𝐏$ = € 𝟏𝟐𝟒𝟏. 𝟐 / $ 𝟕𝟓𝟓. 𝟑 = € 𝟏. 𝟔𝟒 / $𝟏
• If the spot exchange rate is 1.4 Euros per 1 dollar, subsequently, traders use arbitrage.
• The CPI in U.S. in Euros is 1057.42 (or $755.3 * 1.4 €/$) which is smaller than the
CPI of the Euro area.
• Thus, traders could profit by purchasing a basket of goods from US and selling it in
the Euro area. Thus, they potentially earn €1,241.20 – €1,057.42 = €183.78 per basket
of goods.
 Absolute PPP and Relative PPP
• The statement that exchange rates equal relative price levels is sometimes referred to as the absolute PPP.
• Absolute PPP implies a proposition known as the relative PPP, which states that the percentage change in the
exchange rate between two currencies over any time period equals the difference between percentage
changes in national price levels during the same time period.
• Relative PPP thus translates absolute PPP from a statement about price and exchange rate levels into one
about price and exchange rate changes.
• It asserts that prices and exchange rates change in a way that preserves the ratio of each currency’s domestic
and foreign purchasing power.
• Foreign country’s (Euro area in our example) inflation between now and period T = 𝜋€
• Domestic country’s (US in our example) inflation between now and period T = 𝜋$
• 𝐸0€ ⁄$ and 𝐸T€⁄$ are the domestic exchange rates (defined as euros per dollar) measured at time 0 and T.
• Thus, the exchange rate at time 0 is 𝐸0€⁄$ =P€/P$
• The exchange rate at time T is 𝑬𝑻€⁄$ = 𝑷€(𝟏+𝝅€)/ 𝑷$(1+𝝅$)
• Exchange rate change will then be:

• If the US price level rises by 10 percent over a year and Euro area’s rises by only 5
percent, for example, relative PPP predicts a 5 percent depreciation of the dollar
against the euro.
• The dollar’s 5 per cent depreciation against the Euro just gets cancelled with the 5
per cent extra inflation in the US than the Euro area, leaving the relative domestic
and foreign purchasing powers of both currencies unchanged.
• If the US price level rises by 10 percent over a year and Euro area’s rises by
only 5 percent, for example, relative PPP predicts a 5 percent depreciation of
the dollar against the euro.
• The dollar’s 5 per cent depreciation against the Euro just gets cancelled with
the 5 per cent extra inflation in the US than the Euro area, leaving the relative
domestic and foreign purchasing powers of both currencies unchanged.
Limitations

I. Ignores Investment Flows – Exchange rates are also influenced by

capital movements, not just trade and price levels.
II. Choice of Price Index – Uncertainty over whether to use consumer
prices, producer prices, or other indices for accurate calculations.
III. Base Period Selection – Difficulty in determining the appropriate
equilibrium period to compare price levels.
IV. Government Intervention – Trade restrictions, tariffs, and currency
controls can disrupt the free operation of PPP.