Purchasing Power Parity – How it impacts the Market Exchange rate

8/8/2019 Purchasing Power Parity How it impacts the Market Exchange rate

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Purchasing Power Parity

How it impacts the Market

Exchange rate

Presented By Group I2


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PURCHASING POWER PARITY AN

INTRODUCTION

PPP Exchange rate between two countries at

which the their currencies have the same

purchasing power

At PPP exchange rate, a basket of goods will costthe same in both the countries

PPP measurement is a complex task since it is

difficult to decide which items to include in the

basket of goods

Different countries consume different basket of

goods

Example of a PPP measure Big Mac Index


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BIG MAC INDEX

Its an informal but very popular way of measuringPPP between two countries. It is published by TheEconomist

Its based on the price of Big Mac, a hamburger soldat most McDonald's restaurants

Here the "basket of goods" taken is the single BigMac burger and its price is compared across thedifferent countries to arrive at the PPP exchange rate

The two prominent reasons why the Big Mac ischosen for measuring PPP is that

- It is available in almost all countries and theingredients

of Big Mac remain same across many countries

- It is a simple and easy way of measuring and

understanding the PPP


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BIG MAC INDEX


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PPPAS A THEORY OF EXCHANGE RATE

DETERMINATION

PPP theory explains changes in countrys marketexchange rate

According to it, if the cost of a basket of goods isdifferent in two countries, then profit-seekingindividuals will buy the goods in the low costcountry and resell them in the high cost country

This behaviour of importers and exporters willaffect the demand and supply of currencies in theForex market

Hence it will impact the spot exchange rate

Example of US and Mexican markets UScurrency is dollar and Mexican currency is Pesos

PPP exchange rate, EPPPP/$ = CBP /CB$


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SCENARIOS

Scenario I Market exchange rate is greater than thePPP exchange rate

EP/$ > CBP /CB$EP/$ CB$ > CBP

This implies that on an average US goods are moreexpensive than Mexican goods

This will cause US importers to purchase more of theless expensive goods in Mexico

To purchase goods from Mexico, they will have toraise the supply of dollars in the Forex in exchangefor pesos

Thus, the supply curve of dollars on the Forex Marketwill shift to the right


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CONTD Also, Mexican importers will buy less

of the more expensive US goods

This will lead to a reduction indemand for dollars in exchange forpesos on the Forex market

Hence the demand curve for dollarson the Forex will shift to the left

Due to the demand decrease and thesupply increase, the exchange rate,Ep/$ will fall

This means that the dollar willdepreciate and the peso will

appreciate This will continue till the exchange

rate equals the PPP exchange rate ,that is the cost of the basketsbecome equal in both the countries


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CONTD

Scenario II Market exchange rate islower than the PPP exchange rate

EP/$ < CBP /CB$ EP/$ CB$ < CBP This implies that on an average US

goods are cheaper than Mexican

goods This will cause Mexican importers to

buy more of the cheaper goods in US

To buy more US goods, Mexicanimporters will have to increase the

demand for US dollars in exchangefor pesos on the foreign exchangemarket.

This will cause a rightward shift inthe US dollar demand on the ForexMarket


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CONTD

Also, US importers will buy less of the moreexpensive Mexican goods

This will reduce the supply of dollars in exchangefor pesos on the Forex

This will cause a leftward shift in the US dollarsupply curve in the Forex market.

Both the shift in demand and supply will causethe exchange rate, Ep/$ to rise

This means that the dollar will appreciate andthe peso will depreciate

This will continue till the exchange rate equalsthe PPP exchange rate , that is the cost ofbaskets becomes equal in both countries


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PROBLEMS AND EXTENSIONS OF PPP

PPP condition is rarely satisfied in the country

Market exchange rate is rarely the same as the

PPP exchange rate

Reasons- Transportation costs and trade restrictions

- Non tradable inputs drive the prices of the

baskets different

- Individuals do not have perfect informationabout the prices of goods in other markets


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PPP IN THE LONG RUN

It is rare for the PPP relationship to hold true

between any two countries, at any particular

point in time

Economists think of PPP as a 'Long-Run" theoryof exchange rate determination rather than a

short run theory

Rationale for Long run theory - importers and

exporters cannot respond quickly to price

differences in the baskets between countries

When there is a delayed response, PPP no longer

holds at a particular point in time


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CONTD

But eventually traders will adjust to the price

differences by buying in low priced markets and

selling high priced markets

This will cause an eventual adjustment of thespot exchange rate towards the PPP rate

As adjustment occurs, it is possible that the PPP

exchange rate also continues to change

In that case, the spot exchange rate is adjustingtowards a constantly changing PPP

Hence, the Exchange rate may never be able to

catch up with the PPP rate


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LONG RUN PPP THEORY

PPP rate hardly ever

equals the marketexchange rate

Market exchange rate

follows the same trend

as the PPP exchange

rate


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WHAT CAUSES CHANGE IN PPP EXCHANGE

RATE?

PPP exchange rate depends on the price of the

basket of goods in the two countries

Price of the basket of goods in turn depends on

the inflation rates in the two countries If the inflation rates are same in both countries,

the ratio of the cost of the baskets remains the

same

Hence PPP exchange rate remains the same

Differential inflation rates will drive the cost of

the basket of goods different. Hence PPP rate will

change


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OVERVALUATION AND UNDERVALUATION

OF ACURRENCY

Overvaluation

If the US dollar is overvalued with respect to the

Mexican peso, then the spot exchange rate exceeds

the PPP exchange rate

- EP/$ > EPPP

P/$

- EP/$ > CBP /CB$

- EP/$ CB$ > CBP

Cost of the basket in US converted to pesos at the

current spot exchange rate is greater than cost of the

basket in Mexico also evaluated in pesos

Goods and services cost more on average in the US

than in Mexico


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Undervaluation If the US dollar is undervalued with respect to

the Mexican peso, then the spot exchange ratewill be lower than the PPP exchange rate

- EP/$ < EPPP

P/$

- EP/$ < CBP /CB$- EP/$ CB$ < CBP Cost of the basket in US converted to pesos at

the current spot exchange rate is less than cost ofthe basket in Mexico also evaluated in pesos

Goods and services cost less on average in the USthan in Mexico

OVERVALUATION AND UNDERVALUATION

OF ACURRENCY


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APPLICATIONS OF PPP

Cross country comparisons Income, GDP, per

capita GDP,etc

Helps in converting the figures to same units

that can be compared Spot exchange rate does not paint the true

picture

PPP gives a measure of the true welfare of the

people


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Thank You

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Purchasing Power Parity – How it impacts the Market Exchange rate