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FINS3616 Tutorials - Week 3, Questions

1. The purchasing power of money indicates the amount of goods and services that can be purchased with a given amount of money in a country. It is measured by calculating the price level, which is the average price of goods and services in an economy. 2. If the actual euro/pound exchange rate is less than the rate predicted by PPP, then the euro is overvalued and the pound is undervalued. For the rates to align with PPP, the euro would need to weaken and the pound would need to strengthen. 3. It is better to use PPP exchange rates rather than actual rates to compare incomes across countries because PPP rates account for differences in domestic purchasing power. This allows

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188 views

FINS3616 Tutorials - Week 3, Questions

1. The purchasing power of money indicates the amount of goods and services that can be purchased with a given amount of money in a country. It is measured by calculating the price level, which is the average price of goods and services in an economy. 2. If the actual euro/pound exchange rate is less than the rate predicted by PPP, then the euro is overvalued and the pound is undervalued. For the rates to align with PPP, the euro would need to weaken and the pound would need to strengthen. 3. It is better to use PPP exchange rates rather than actual rates to compare incomes across countries because PPP rates account for differences in domestic purchasing power. This allows

Uploaded by

Lena Zheng
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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FINS3616 Tutorials – Week 3

(Purchasing Power Parity)

1. What does the purchasing power of a money mean? How can it be measured?

The purchasing power of a money Is the real value and indicates the amount of goods and services that can be
purchased with a given amount of money e.g. $1. Purchasing power is measured by calculating the price level,
which is the weighted average of the prices of the goods and services that people consume. The purchasing
power of money is the reciprocal of the price level. This indicates the amount of consumption bundles per unit
of money.

2. If the actual exchange rate for the euro value of the British pound is less than the exchange rate that would
satisfy absolute PPP, which of the currencies is overvalued and which is undervalued? Why?

If the actual exchange rate of euros per pound is less than the PPP prediction, the euro is overvalued and the
pound is undervalued. If actual exchange rate were to move to the PPP prediction, the euro would have to
weaken and pound would have to strengthen. The weakening of the euro would correct its overvaluation and
strengthening of the pound would correct its undervaluation.

3. Why is it better to use a PPP exchange rate to compare incomes across countries than an actual exchange
rate?
Compare the quality of life and consumption. By multiplying the nominal incomes with the respective purchasing
power of the currencies or dividing nominal income by the price level. The real value of the income tells you the
goods and services that the nominal income provides when you consume in that country.

Purchasing power parity exchange rate ^

4. What is relative PPP, and why does it represent a weaker relationship between exchange rates and prices
than absolute PPP?

The theory of relative PPP specifies that exchange rates adjust in response to differences inflation rates across
countries to leave the deviation of the actual exchange rate from absolute PPP unchanged
 Inflation is the rate of loss of the internal purchasing power of a currency
 Thus, if two currencies are losing internal purchasing power at different rates because the rates of
inflation in the two countries are not equal, the rate of change of the exchange rate can offset the
differential rates of inflation to leave the same absolute relationship between the internal and external
purchasing powers of the currencies
 Relative PPP theory is weaker than absolute PPP because relative PPP could be satisfied even though
there are deviations from absolute PPP
 The requirement for relative PPP to hold is that the deviations from absolute PPP do not change over
time

5. What is the real exchange rate, and how are fluctuations in the real exchange rate related to deviations
from absolute PPP?

The real exchange rate, say, of the dollar relative to the euro, is denoted RS(t,$/€). It is defined to be the
nominal exchange rate multiplied by the ratio of the price levels:
RS(t,$/€) = S(t,$/€) x P(t,€)/P(t,$)
Notice that the real exchange rate would be 1 if absolute purchasing power parity held because the nominal
exchange rate, S(t,$/€), would equal the ratio of the two price levels, P(t,$)/P(t,€). Similarly, if absolute PPP is
violated, the real exchange rate is not equal to 1.
Th u s, flu ctuation s in th e d eviation s from ab solute PPP are flu ctuation s in th e real exchange
rate

6. If the nominal exchange rate between the Mexican peso and the U.S. dollar is fixed, and there is higher
inflation in Mexico than in the United States, which currency experiences a real appreciation and which
experiences a real depreciation? Why? What is likely to happen to the balance of trade between the two
countries?

7. Suppose that the rate of inflation in Japan is 2% in 2011. If the rate of inflation in Germany is 5% during
2011, by how much would the yen strengthen relative to the euro if relative PPP is satisfied during 2011?

The yen should strength en by the differential in the rates of inflation or 5% - 2% = 3%. The exact
answer incorporates a denominator correction, and we get

Since we are concerned about the strengthening of the yen, let the yen be the foreign currency (FC), and
let the euro be the domestic currency (DC). Then, the relative PPP formula states that the rate of
appreciation of the yen is 0.05 - 0.020.0294 or 2.94%1 + 0 . 0 2

8. One of your colleagues at Deutsche Bank thinks that the dollar is severely undervalued relative to the yen.
He has calculated that the PPP exchange rate is ¥140/$, whereas the current exchange rate is ¥105/$.
Because interest rates are 3% p.a. lower in Japan than in the United States, he thinks that this is a good time
to speculate by borrowing yen and lending dollars. What do you think?

 Deviations from PPP are a weak reason to engage in speculation.


 While the data in the problem indicate that the dollar is 33.33% undervalued, because that
is the amount of dollar appreciation that would be required to take the actual exchange rate from
¥105/$ to the PPP prediction of ¥140/$, we know that the return to PPP will not be an overnight
event.
 The empirical analysis of the issue indicates that the half-life of PPP deviations is around 5
years. Thus, you might expect that the dollar will appreciate by 16.67% over the next 5 years.
 But, uncovered interest rate parity actually suggests that the yen will appreciate in the short
run, because the yen interest rate is 3% less than the dollar interest rate. Notice, though, that the
correction back toward PPP can take place with differential rates of inflation in the two
countries.
 I f J a p an e s e r a t e o f in f l at i o n f a l l s b e l o w th e U . S . r a t e o f in f l a t io n , th e PP P
prediction will begin falling toward the actual exchange rate. Finally, although the dollar is
33.33% undervalued, there is no guarantee that the undervaluation will begin to be corrected
now. It may, in fact, get worse. If the undervaluation of the dollar goes to 50% over the next 2
years, you would lose 16.67% in the foreign exchange market which would not
b e compensated by the approximate 6% that you would earn by borrowing yen and
lending dollars. Finally, do not forget that your boss in proprietary trading at Deutsche Bank
would not be happy with such a situation
9. Suppose that in 2011, the Japanese rate of inflation is 2%, and the German rate of inflation is 5%. If the euro
weakens relative to the yen by 10% during 2011, what would be the magnitude of the real depreciation of
the euro relative to the yen?

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