Purchasing Power Parity and Exchange Rate

8/9/2019 Purchasing Power Parity and Exchange Rate

1/16


2/16

Purchasing power parity & Exchange ratePurchasing power parity & Exchange rate


3/16


4/16

Introduction

The theory of Purchasing Power Parity (PPP) explainsmovements in the exchange rate between two countriescurrencies by changes in the countries price levels.

In short, what this means is that a bundle of goods shouldcost the same in Canada and the United States once you takethe exchange rate into account.


5/16

Purchasing Power Parity &

Base ball Bat

y Suppose that one U.S. Dollar (USD) is currently selling for10 Pakistani rupees (PKR) on the exchange rate market.

y In the United States, Same wooden baseball bats sell for40(USD).

y While in Pakistan they sell for 150 (PKR). Since 1 USD =10(PKR), then the bat costs $40 USD if we buy it in the U.S. butonly 15 USD if we buy it in Pakistan.

y Clearly there's an advantage to buying the bat in Pakistan,so consumers are much better off going to Pakistan to buytheir bats.


6/16

Ifconsumers decide to do this, we should expect

to see three things happen:

y American consumers desire Pakistani Currency in order to buybaseball bats in Pakistan. So they go to an Exchange office andsell theirAmerican Dollars and buy Pakistani rupee at presentrate.

y This will cause the Pakistani rupee to become more valuablerelative to the U.S. Dollar.

y The demand for baseball bats selling in the United States

decreases, so the price American retailers charge goes down.

y The demand for baseball bats selling in Pakistan increases, sothe price Pakistani retailers charge have value.


7/16

But...

y If the U.S. Dollar value declines to 1 USD = 8 (PKR) and the priceof baseball bats in the United States goes down to $30 each and

the price of baseball bats in Pakistan goes up to 240 (PKR) each.

y There we will have Purchasing Power Parity(PPP). Because ofthis consumer will pay $30 in the United States for the baseballbat, or he can take his $30, exchange it for 240 (PKR) and buy thesame baseball bat in Pakistan and be no better off.


8/16

Purchasing Power Parity

y Now if we will take another example:

Let, we comsider prices of BIG Mac in the world.

We take two countries China and United States. We will

consider BIG Mac prices in these two countries. A Big Mac in China costs 10.5 Yuan which at the current

exchange rate of

$US1 = 7. 7431Yuan

means that in China the Big Mac costs $US1.356.


9/16

Purchasing Power Parity.

y To obtain this, divide the foreign currency price (10.5 Yuan),by 7.7431, the number of foreign currency units to a unit of

the currency in which we wish to obtain the price ($US).

y As we know that in China BIG Mac Costs 10.5(Yuan),

So, 7.7431Yuan is equal to 1US$

= $US1.356

Note that in the United States, a Big Mac costs $US3.10


10/16


y So a BIG Mac is cheaper in China, than in US currency inthe United States, at the existing exchange rate.

y So the US. dollar is overvalued and the Chinese Yuanundervalued given the Big Mac prices.


11/16


y In order to obtain the PPP exchange rate,

y Divide the BIG Mac price in China in Yuan, by the BIG Mac

price in the US. in US. currency.So,10.5/3.10 = 3.387

y This says, $US1 should equal 3.387 Yuan for the Big Mac tobe the same price in both countries, in either currency.

y So,if we multiply 3.10 with 3.387 it will be equal to 10.5

y And 10.50/3.387 = 3.10


12/16


y From this we can calculate the extent of the over orundervaluation of a currency.

y PPP Actual Ex. Rate = % under or

Actual Ex. Rate overvaluation


13/16


y So in this example,

3.387 7.7431 =- 4.3561

7.7431 7.7431

= - .5626

So the Chinese Yuan is undervalued 56.26%against the US. dollar.


14/16

Law ofOne Price &The Purchasing

Power Parity theory

When we extend law of one price from one good to basket of goods, it becomes Purchasing Power Parity theory of exchangerate determination.

The Purchasing Power Parity (PPP) theory is based on theassumption that real exchange rates are fixed.

Thus it means that differences in the inflation rate in the twocountries causes changes in nominal exchange rate between

two countries.

It states that whenever a countrys price level is expected to fallrelative to other countrys price level, its currency shouldappreciate relative to other countrys currency.


15/16

Law ofOne Price and The Purchasing

Power Parity theory

y Movements in exchange rates not completely consistent withPPP theory:

y For differentiated products, law of one price does not hold,

e.g. Kodak and Sony camera.y Not all goods and services (e.g. haircut, sandwich) are

internationally traded.

y Significant differences in prices of non-traded goods and

services are not completely reflected in exchange rates.y The assumption of constant real exchange rate is not

reasonable. There may be shifts in preferences for domesticor foreign goods and trade barriers.


16/16

Documents

Purchasing Power Parity and Exchange Rate