1. Purchasing Power Parity Bill Reese International Finance 1

2. 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

3. 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

4. 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

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

6. 6 Country BigMac PriceXR in Local Currencyin US dollars United States$ 3.413.411 ArgentinaPeso 8.252.60763.1638 AustraliaA$ 3.453.11431.1078 BrazilReal 6.93.96031.7423 Britain£ 1.993.94220.5048 CanadaC$ 3.883.78281.0257 ChilePeso 15653.4801449.7 ChinaTuan 111.55757.0625 ColombiaPeso 69003.72621851.76 DenmarkDkr 27.755.72834.8444 EygptPound 9.541.70065.6098 Euro area€ 3.064.7120.6494 Hong KongHK$ 121.54257.7798 HungaryForint 6003.5877167.236 IcelandKronur 4695.92979.1033 Japan¥ 2802.7989100.038 MalaysiaRinggit 5.51.69843.2383 MexicoPeso 292.704610.7223 New ZealandNZ$ 4.63.64471.2621 NorwayKroner 407.57095.2834 PakistanRupee 1402.252662.1508 ParaguayGuarani 105002.24914668.6 PhilippinesPeso 852.03341.8106 PolandZloty 6.93.00542.2959 RussiaRouble 522.182623.8243 Saudi ArabiaRiyal 92.39623.756 SingaporeS$ 3.952.84131.3902 South AfricaRand 15.51.8988.1664 South KoreaWon 29002.81971028.49 SwedenSkr 335.38826.1245 SwitzerlandSFr 6.36.19411.0171 TaiwanNT$ 752.488830.1354 ThailandBaht 621.957831.6678 UruguayPeso 622.942421.071 VenezuelaBolivar 74003.43932151.61

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

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

9. 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

10. 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

11. Relative PPP (1 +.03) = St+1 = 1+ΔS$/P (1 +.05).37 1+ΔS$/P = 0.981 → 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

12. 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

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

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

15. 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

16. 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