Chapter 8: Purchasing Power Parity
and Real Exchange Rates
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
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Chapter 8: Purchasing Power Parity
and Real Exchange Rates
8.1
Price Level and Price Indexes
8.2
The Purchasing Power of a Currency
8.3
Absolute Purchasing Power Parity
8.4
The Law of One Price
8.5
Describing Deviations from PPP
8.6
The MacPPP Standard
8.7
Exchange Rates and Absolute PPPs Using CPI Data
8.8
Explaining the Failure of Absolute PPP
8.9
Comparing Incomes Across Countries
8.10
Relative Purchasing Power Parity
8.11
The Real Exchange Rate
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8.1 Price Level and Price Indexes
Price Level and Price Indexes: Overview
• The General Idea of Purchasing Power
• Calculating the Price Level
• Calculating a Price Index
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8.1 Price Level and Price Indexes
• The General Idea of Purchasing Power
• Nominal price
• Price level
• Inflation/Deflation
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8.1 Price Level and Price Indexes
• The General Idea of Purchasing Power
• Nominal price
• Price level
• Inflation/Deflation
• Calculating the Price Level
• Calculating a Price Index
• Price index
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8.1 Price Level and Price Indexes
• Calculating the Price Level
• Calculating a Price Index
• Price index
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Exhibit 8.1
Price Indexes for the G7 Countries, 1960-2005
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8.2 The Purchasing Power of a Currency
A Currency’s Purchasing Power: Overview
• Internal Purchasing Power
• External Purchasing Power
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8.2 The Purchasing Power of a Currency
• Internal Purchasing Power
• The power of the dollar when it is used within the
United States to purchase goods and services
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8.2 The Purchasing Power of a Currency
• External Purchasing Power
• The power of the U.S. dollar when it is used to
purchase good and services outside of the United
States
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8.3 Absolute Purchasing Power Parity
Absolute Purchasing Power Parity
• States that the exchange rate adjusts to equalize
the internal with external purchasing powers of a
currency.
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8.4 The Law of One Price
The Law of One Price: Overview
• The Perfect Market Ideal
• Why Violations of the Law of One Price Occur
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8.4 The Law of One Price
• The Perfect Market Ideal
• The law of one price:
• The price of a commodity, when denominated
in a particular currency, is the same wherever
in the world it is sold when denominated in
another currency.
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8.4 The Law of One Price
• Why Violations of the Law of One Price Occur
• Tariffs and quotas
• Transaction costs that prevent trade
• Speculation
• Noncompetitive markets
• Pricing to market
• Sticky prices
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8.5 Describing Deviations from PPP
Deviations from PPP: Overview
• Overvaluations and Undervaluations of Currencies
• Predictions Based On Overvaluations and
Undervaluations
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8.5 Describing Deviations from PPP
• Overvaluations and Undervaluations of
Currencies
• Currency overvalued when its external purchasing
power exceeds its internal purchasing power
• Currency undervalued when its external
purchasing power is less than its internal
purchasing power
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8.5 Describing Deviations from PPP
• Predictions Based On Overvaluations and
Undervaluations
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8.6 The MacPPP Standard
The MacPPP Standard: Overview
• The Big Mac as a Price Index
• Comparing Prices Across Countries
• Some Predictions of Currency Appreciations
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8.6 The MacPPP Standard
• The Big Mac as a Price Index
• Advantages to use:
• Standard product globally
• Local suppliers used reducing transit costs
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8.6 The MacPPP Standard
• Comparing Prices Across Countries
– Local Currency and Dollar Prices
– Implied PPP Exchange Rates
– Overvaluations and Undervaluations
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Exhibit 8.2
MacPPP in 2006
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8.6 The MacPPP Standard
• Some Predictions of Currency Appreciations
– Predicting British Heartburn
– Predicting Initial Weakness of the Euro
– The Econometric Evidence
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Interpreting the Charts
– Overvaluations and Undervaluations
– Fixing When PPP Held
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Dollar-Pound Data
– Exhibit 8.3
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Exhibit 8.3
Actual USD/GBP and PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Deutsche Mark-Dollar Data
– Exhibit 8.4
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Exhibit 8.4
Actual DEM/USD and PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Yen-Dollar Data
– Exhibit 8.5
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Exhibit 8.5
Actual JPY/USD and PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Canadian Dollar-U.S. Dollar Data
– Exhibit 8.6
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Exhibit 8.6
Actual CAD/USD and PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• French Franc-Deutsche Mark Data
– Exhibit 8.7
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Exhibit 8.7
Actual FRF/DEM and Implied PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Italian Lira-Deutsche Mark Data
– Exhibit 8.8
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Exhibit 8.8
Actual ITL/DEM and PPP Exchange Rates
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8.7 Exchange Rates and Absolute
PPPs Using CPI Date
• Mexican Peso-Dollar Data
– Exhibit 8.9
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Exhibit 8.9
Actual MXP/USD and PPP Exchange Rates
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8.8 Explaining the Failure of Absolute PPP
The Failure of Absolute PPP: Overview
• Changes in Relative Prices
• Non-Traded Goods
• PPP Deviations and the Balance of Payments
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8.8 Explaining the Failure of Absolute PPP
• Changes in Relative Prices
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8.8 Explaining the Failure of Absolute PPP
• Non-Traded Goods
– Housing
– Technological Change
• PPP Deviations and the Balance of Payments
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8.9 Comparing Incomes Across Countries
Comparing Incomes Across Countries:
Overview
• Comparing Incomes in New York and Tokyo
• Comparing GDPs Using PPP Exchange Rates
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8.9 Comparing Incomes Across Countries
• Comparing Incomes in New York and Tokyo
• Incorporating purchasing power
• Working with the PPP rate
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8.9 Comparing Incomes Across Countries
• Comparing GDPs Using PPP Exchange Rates
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Exhibit 8.10
GDP per Capita for
OECD Countries in 2006
Using Exchange Rates
and PPP Values
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8.10 Relative Purchasing Power Parity
Relative Purchasing Power: Overview
• Introduction
• A General Expression for Relative PPP
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8.10 Relative Purchasing Power Parity
• Introduction
• Relative purchasing power parity:
• Exchange rates adjust in response differences
in inflation rates across countries leaving the
differences in purchasing power unchanged
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8.10 Relative Purchasing Power Parity
• A General Expression for Relative PPP
• The logic of relative PPP
• A symbolic representation of relative PPP
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8.10 Relative Purchasing Power Parity
• Introduction
• Relative purchasing power parity
• A General Expression for Relative PPP
• The logic of relative PPP
• A symbolic representation of relative PPP
• Relative PPP with Continuously Compounded Rates
of Change (Advanced)
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8.11 The Real Exchange Rate
The Real Exchange Rate: Overview
• The Definition of the Real Exchange Rate
• Real Appreciations and Real Depreciations
• Trade-Weighted Real Exchange Rates
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8.11 The Real Exchange Rate
• The Definition of the Real Exchange Rate
• A nominal exchange rate that is adjusted by the
ratio of the price levels in two countries
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8.11 The Real Exchange Rate
• Real Appreciations and Real Depreciations
• The percentage change in the real exchange rate
• What leads to real appreciations or depreciations
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8.11 The Real Exchange Rate
• Trade-Weighted Real Exchange Rates:
• An average of all the bilateral real exchange
rates of a country using the relative amount of
trade between countries as weights
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Exhibit 8.11
Actual ARS/USD and PPP Exchange Rates
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