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PRESENTED BY VEERESH AND SANTHOSH.M
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
Theories of exchange rate
Purchasing Power Parity
The PPP theory focuses on the inflation – exchange
If the law of one price holds for all goods and
services, we can obtain the theory of PPP.
LAW OF ONE
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
If not, arbitrage opportunities exist
Assumes that there will be no shipping costs, tariffs,
Relates to a particular commodity, security, asset
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate
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€
= 1.2028 $/€ 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
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
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
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 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
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
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
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
costs Tariffs and
goods & services
and non tradable
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
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
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.