Purchasing Power Parity Bill Reese International Finance 1

Learning Objectives In this unit we will learn:  What the law of one price is  Why absolute PPP doesn’t always hold  What relative PPP is  About the International Fisher Effect 2

Law of One Price The law of one price  The same good will cost the same everywhere  No arbitrage opportunities  Can’t buy diamonds in Canada and sell them in U.S. 3

Law of One Price P D = S direct x P F  The price of a good domestically is the same as its price on a foreign market, adjusted for the spot direct exchange rate 4

Law of One Price Absolute Purchasing Power Parity  Often doesn’t hold  Presumes frictionless markets Transportation costs Taxes Non-identical goods 5

6 Country BigMac PriceXR in Local Currencyin US dollars United States$ ArgentinaPeso AustraliaA$ BrazilReal Britain£ CanadaC$ ChilePeso ChinaTuan ColombiaPeso DenmarkDkr EygptPound Euro area€ Hong KongHK$ HungaryForint IcelandKronur Japan¥ MalaysiaRinggit MexicoPeso New ZealandNZ$ NorwayKroner PakistanRupee ParaguayGuarani PhilippinesPeso PolandZloty RussiaRouble Saudi ArabiaRiyal SingaporeS$ South AfricaRand South KoreaWon SwedenSkr SwitzerlandSFr TaiwanNT$ ThailandBaht UruguayPeso VenezuelaBolivar

Law of One Price Can you buy a load of Big Macs in China, sell them in Norway, and earn an arbitrage profit? 7

Law of One Price Relative Purchasing Power Parity  Changes in prices  Not absolute prices  Relative inflation or deflation  Usually holds 8

Relative PPP (1 + ΠD) = St+1 = 1+ΔSD/F (1 + ΠF) St Countries with higher inflation should see their currency depreciate Inflation expectations gives us XR expectation 9

Relative PPP Example: Expected inflation rate in U.S. next year is 3.0% Expected inflation rate in Mexico next year is 5.0% Current spot rate 2.7 pesos/$ =.37 $/peso 10

Relative PPP (1 +.03) = St+1 = 1+ΔS$/P (1 +.05).37 1+ΔS$/P = → ΔS$/P= -1.9% St+1 =.363 $/peso =2.755 peso/$ Peso expected to depreciate by 1.9% Dollar expected to appreciate by 1.9% 11

International Fisher Effect Fisher effect  1 + real rate = 1 + nominal rate  1 + inflation rate  100 →107  100 →103  (1.07/1.03) – 1 = 3.88% 12

International Fisher Effect Investors concerned with real rate (gain in purchasing power) – invest where it is highest Real rates will equalize across countries 13

International Fisher Effect Differences in nominal rates across countries are due to differences in inflation expectations Real rates will equalize across countries 14

International Fisher Effect  Currency values will Δ in amount equal to, but in opposite direction from difference in nominal interest rates If nominal rates only vary by inflation expectations 15

International Fisher Effect Often doesn’t hold Investors will look to make money in “carry trade” by borrowing in currency with lower rate and investing in currency with higher rate 16