MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

INTRODUCTION: 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 at par with the purchasing power of the two countries' currencies.exchange ratepurchasing power Concept: The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.School of SalamancaGustav Cassellaw of one pricetransaction coststrade barriers MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

Meaning: Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. OR the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent. In brief, in ideally efficient markets, identical goods should have only one Price. MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

EXAMPLE MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

Definition The theory that, in the long run, identical products and services in different countries should cost the same in different countries. This is based on the belief that exchange rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another.long runproductsservicessameexchange rateseliminatearbitragebuyingselling The result of goods market arbitrage is that the prices of goods in different countries expressed in a common currency tend to be equalized. Applied to a single good, this idea is referred to as the law of one price; applied to an entire basket of goods, it is called the theory of purchasing power parity. MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

Forms of PPP Absolute form Relative form 1.ABSOLUTE PURCHASING POWER PARITY A. Price levels adjusted for exchange rates should be equal between countries. B. One unit of currency has same purchasing power globally. MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

2. RELATIVE PURCHASING POWER PARITY states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries. The relative version of PPP is calculated as: Where: "S" represents exchange rate of currency 1 to currency 2 "P 1 " represents the cost of good "x" in currency 1 "P 2 " represents the cost of good "x" in currency 2currency MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

It may seem as if PPPs and the law of one price are the same, there is a difference: ‘the law of one price applies to individual commodities whereas PPP applies to the general price level’.law of one price The law of one price (LOOP) states that in the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual sellers or buyers have power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

PPP in Mathematical Terms 1.In mathematical terms: where e t = future spot rate e 0 = spot rate i h = home inflation i f = foreign inflation t= the time period MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be : 3.A more simplified but less precise relationship is that is, the percentage change should be approximately equal to the inflation rate differential. MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations. R = (1+a) (1+I) According to the Fisher Effect, countries with higher inflation rates have higher interest rates. EXAMPLE: Suppose the required rate of return is 5% & the expected rate of inflation is 8%, the required nominal int rate would be: R = (1+0.05)(1+0.08) R = 13.40% MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

IFE states that the spot rate adjusts to the interest rate differential between two countries. IFE = PPP + FE MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)

IFE Implications 1. Currencies with low interest rates would appreciate with respect to currencies with high interest rates. 2. A long-run tendency for interest rates differentials to offset exchange rate changes has been demonstrated empirically. Example: Interest rate in U.S. is 4%, while interest rate in Switzerland is 10%. If the current SF spot rate is $0.80, what should be the SF spot rate one year from now? $0.80 × 1.04/1.10 = $ per SF Or SF depreciates about 5.5% MS. Priya - Teaching Asstt (BPSMV Khanpur Kalan)