Chapter 14
Prices and
Exchange Rates:
Purchasing
Power Parity
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Topics to be Covered
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Purchasing Power Parity (PPP)
Absolute PPP
Law of One Price
Relative PPP
Deviations from PPP
Overvalued vs. Undervalued Currencies
Real Exchange Rate
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Purchasing Power Parity
• Purchasing Power Parity (PPP)—
the relationship between prices and
exchange rates which asserts that as prices
change internationally, exchange rates must
also change to keep prices measured in a
common currency equal across countries.
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Two Views of PPP
• Absolute Purchasing Power Parity
• Relative Purchasing Power Parity
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Absolute PPP
• The Absolute Purchasing Power Parity
relation is:
where P is the domestic price index, PF the
foreign price index, and E is the spot
exchange rate (domestic currency units per
unit of the foreign currency).
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Absolute PPP (cont.)
• Absolute PPP indicates that the exchange
rate between two currencies is equal to the
ratio of the two countries’ price indexes.
• The exchange rate is a nominal value,
that is, its value is dependent on current
price levels.
• A problem arises when the national price
indexes are not comparable in terms of
product coverage and base year used.
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Law of One Price
• The Absolute PPP equation can be rewritten
as:
where the domestic price level is equal to
the exchange rate times the foreign price
level. This is called the law of one price,
indicating that similar goods sell for the
same price worldwide.
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Problems with Law of One
Price
• The more homogeneous goods are, the
more the law of one price is expected to
hold.
• There are obstacles to equalization of
product prices across countries, including
differentiated products and costly
information.
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Problems with Absolute PPP
• Absolute PPP may not hold due to:
– Transportation costs and tariffs are present.
– National price indexes capture the prices of
goods that are not traded internationally.
– Changes in the exchange rate may be due to real
rather than nominal economic events. Real
events, such as relative price changes resulting
from a poor harvest, may cause deviations from
absolute PPP as the exchange rate changes, even
if the price indexes remain constant.
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Relative Purchasing Power
Parity
• Relative PPP is said to hold if:
where a caret (^) over a variable indicates
percentage change. Relative PPP states that
the percentage change in the exchange rate
is equal to the percentage change in the
domestic price level minus the percentage
change in the foreign price level.
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Relative PPP (cont.)
• Alternatively, relative PPP states that the
percentage change in the exchange rate is
equal to the inflation differential between the
domestic and foreign countries.
• If absolute PPP holds, then relative PPP also
holds. If absolute PPP does not hold, relative
PPP may still hold.
• Real events which cause relative price
changes are often random or unexpected.
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Time, Inflation, and PPP
• Some studies have found that PPP holds
better for high-inflation countries.
• Studies have found that PPP holds well in
the long run.
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PPP on a Monthly vs. Annual
Basis
• Refer to Figure 14.1
• The exchange rates are more variable than
the inflation differentials.
• Deviations from PPP are more apparent for
monthly than for annual data.
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FIGURE 14.1
U.S.–Japan
Purchasing Power
Parity
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Reasons for Deviations from PPP
• The law of one price does not apply to
differentiated products or to globally non-traded
goods.
• Prices may differ due to freight costs or tariffs.
• Relative price changes may result from real
economic events such as changing tastes, bad
weather, or government policy.
• Since people in different countries consume
different goods, national price indexes may not be
comparable.
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Reasons for Deviations from PPP
(cont.)
• PPP is not a theory of exchange rate
determination. Both prices and exchange
rates are endogenous variables
determined by other given factors such as
bad weather or government policy
(exogenous variables).
• Unexpected information or news (e.g.,
Federal Reserve monetary policy
announcement) may affect both exchange
rates and prices (refer to Figure 14.2).
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FIGURE 14.2 Shifts in the ForeignExchange Market and Deviations from PPP
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Reasons for Deviations from PPP
(cont.)
• Another reason for deviations from PPP is
that international trade transactions involve
time lags between order and delivery.
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Summary: Three Sources of
Deviations from PPP
1. Factors that suggest permanent deviations
(e.g., shipping costs and tariffs).
2. Factors that would produce temporary
deviations (differential speed of
adjustment between financial asset
markets and goods markets, or relative
price changes).
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Summary: Three Sources of
Deviations from PPP (cont.)
3. Factors that cause the appearance of
deviations where none actually exist
(comparing current exchange rates with
prices set in the past, or using national
price indexes when countries consume
different baskets of goods).
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“Overvalued” vs. “Undervalued”
Currency
• Overvalued currency—a currency worth
more than the PPP value.
• Undervalued currency—a currency worth
less than the PPP value.
• Refer to Global Insights: Big Mac PPP
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Real Exchange Rate
• The real exchange rate is measured as:
that is, the real exchange rate is equal to
the nominal exchange rate divided by the
ratio of the domestic and foreign price
indexes.
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