1. Exchange Rates and Purchasing Power Parity
PPP theory of Exchange Rate
Exchange Rates and Purchasing Power Parity
Presented to:
Mr. Ghulam Mustafa
Presented by:
Mirza Usman Ghani (28F-648)
Muhammad Usman (28F-650)
PPP theory of Exchange Rate

2. Exchange Rate
Rate of exchange: the charge for exchanging currency of one country for currency of another
The rate at which one currency may be exchanged for another.
Exchange rates matter in many different ways to many different constituencies in the world economy
Much of this section on international finance will be directly or indirectly concerned with exchange rates
PPP theory of Exchange Rate

3. The Nominal Exchange Rate
Relative price of two currencies
Often expressed as number of units of local or home currency required to buy a unit of foreign currency
We will usually view Pakistan (Rs.) as our home country and United States (dollar) as our foreign country
Nominal or currency exchange rate (e) is
If e increases the value of the Rupee (home currency) falls
If e decreases the value of the Rupee (home currency) rises
e and the value of the Rupee are inversely related
PPP theory of Exchange Rate

4. The Real Exchange Rate
Measures the rate at which two countries’ goods trade against each other
Makes use of the price levels in the two countries under consideration
PPP theory of Exchange Rate

5. The Real Exchange Rate
Suppose that the price level in the United States rises
Takes more Pak goods to purchase US goods
Represents a fall in the real value of the Rs.
Suppose that the price level in Pakistan rises
Takes fewer Pakistani goods to purchase US goods
Represents a rise in the real value of the Rs.
Suppose that the nominal exchange rate increases
Takes more Pak Rupees to buy a US dollar and, therefore, more Pakistani goods to buy US goods
Represents a fall in the real value of the Rupee
PPP theory of Exchange Rate

6. ER classification as per time
Spot Exchange rate refers to the current exchange rate
Forward Exchange rate refers to ER that is quoted and traded today but for delivery and payment in future date
PPP theory of Exchange Rate

7. Fluctuations in Exchange Rates
Fluctuations are mostly due to market exchange rate movements
ER will change whenever the values of either of the component currencies change.
Greater demand than the available supply tends to increase the value of currency and vice versa
PPP theory of Exchange Rate

8. Fluctuations in Exchange Rates ER as per 27th July 2009
PPP theory of Exchange Rate

9. The Purchasing Power Parity Model
PPP is a theory of exchange rate determination and a way to compare the average cost of goods and services between two countries
Purchasing power of a currency in a given country is inversely related to price level in that country
For example, purchasing power of the Rs. In Pakistan can be expressed as
The higher the price level in Pakistan the lower the purchasing power of the Rupee
PPP theory of Exchange Rate

10. PPP Equation Invert the equation
PPP hypothesis is
Invert the equation
Divide both sides of the above equation by PUS to obtain PPP equation
PPP theory of Exchange Rate

11. Meaning of PPP Equation
Suppose PRs were to increase
According to the PPP model, e would increase
Suppose PUS were to increase
According to the PPP model e would decrease
Nominal value of the Rupee adjusts to changes in its real purchasing power in the two countries
PPP theory of Exchange Rate

12. Meaning of PPP Equation
Let $P be the value in Dollar of a representative basket of goods, & the value in Rs of the same basket.
We call $P/Rs.P the PPP Exchange rate
EXAMPLE:
If a representative consumption basket costs $10 in the US and RS 850
in PAK the PPP Exchange rate would be Rs85/$.
PPP theory of Exchange Rate

13. The Law Of One Price
The law of one price simply stays that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between markets are not important
EXAMPLE
Why? Suppose the price of pizza at one restaurant is $20, while the price of same pizza at similar restaurant across the street is $40
PPP theory of Exchange Rate

14. Findings
Using market exchange rates to compare country's standard of living per capita GDP, the picture is not fully clear
The ER only reflects traded goods in contrast to non traded ones.
The PPP model is used an alternative
PPP exchange rates are especially useful when official ER are artificially manipulated by governments
PPP theory of Exchange Rate

15. Thank You
PPP theory of Exchange Rate