1. PURCHASING POWER PARITY

2. DEFINITION
Theory that focuses on the relationship between inflation– exchange rate
It suggests how the differential inflation levels among countries will affect movements of exchange rate

3. 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.

4. NOTE: exchange rate Due to the difference in the level of inflation
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.

5. 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

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

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

8. 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.

9. 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 )

10. 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

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

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

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

14. Graphical Representation

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

16. Example 3 Year : 2011 h : Pakistan f : US Ih : 7 % If : 3 %
I V : $ 1 = Rs 60
Ef : ?
N E V : ?

17. Calculate yourself