PURCHASING POWER PARITY

DEFINITION “Theory that focuses on the inflation – exchange rate relationship ,suggests how the differential inflation levels among countries will affect exchange rate movements”

For PPP to Hold The exchange rate should adjust to offset the differential in the inflation rates of the two countries. If this occurs the prices of goods in either country should appear similar to consumers.

NOTE: rate Due to the difference in the level of inflation of two After the adjustment of foreign country’s exchange rate Due to the difference in the level of inflation of two countries The purchasing power of consumers when purchasing domestic goods will be same as when purchasing foreign goods.

FORMULA Where Ef : Foreign country’s exchange rate Ih : Home inflation Ef = Ih – If Where Ef : Foreign country’s exchange rate Ih : Home inflation If : Foreign inflation

Example 1 Data Ef : ? Ih : 9 % If : 5 %

Calculation Ef = Ih – If = 4 % = 4 % It means foreign currency will appreciate by 4 %

Rationale Behind PPP Theory If there are two countries Produce goods for each other Goods are substitutes for each other If there is inflation in both countries One country has higher inflation Foreign currency will appreciate / depreciate Then there will be no difference in buying from foreign or home country.

From Foreign Prospect The foreigners will reduce buying from home till the foreign currency will appreciate by the difference of inflation among countries ( 4 % in the example )

Using PPP to Assess Future currency movements Formula : N E V = I V * (1 + Ef ) Where N E V : New Equilibrium Value I V : Initial Value Ef : Foreign currency

Example Now $ 2.08 = 1 pound h : US f : UK I V : $ 2 = 1 pound Ef : 4 % N E V = $ 2 * ( 1 + 4 % ) = $ 2.08 Therefore PPP suggests that Now $ 2.08 = 1 pound

Example 2 h : US f : France Ih : 1 % If : 6 % I V : $ .20 = ff 1 Ef : ? N E V : ?

Result Ef : - 5 % N E V : $ .19 = ff 1

Graphical Representation

Why PPP does not consistently hold 1 . Other Influential Factors : Interest Rates high 2 . No Substitutes for traded goods

Example 3 Year : 2002 h : Pakistan f : US Ih : 7 % If : 3 % I V : $ 1 = Rs 60 Ef : ? N E V : ?

Calculate yourself