International Finance

#4. Chapter 4: The theory of purchasing power

parity (PPP) and generalized model of the
exchange rate

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Outline
The Law of One Price
Purchasing Power Parity (PPP)
Empirical Evidence on PPP
Explaining the Problems with PPP
A Long-Run Exchange Rate Model Based on
PPP

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The Law of One Price (LOP)
Law of One Price:
◦ Assume that there are no transportation costs or other trade
barriers.
◦ Then, identical goods are sold at the same price in different
countries when the prices are expressed in terms of the same
currency.

Pt i S t Pt i*
P i the price of homogenous traded good i.
S the nominal exchange rate (home currency price of one unit
of foreign currency).

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The Law of One Price (LOP) (cont’d)
Law of One Price:
◦ Pi = (EVND/$) x (Pi*)
 The VND price of good i is the same wherever it is
sold.

◦ EVND/$ = Pi/Pi*
 The VND/dollar exchange rate is the ratio of good i’s
Vietnamese and US money prices

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Purchasing Power Parity (PPP)
Theory of PPP:
◦ Exchange rates between two countries’ currencies
equals the ratio of the countries’ price levels.
◦ The theory of PPP is simply an application of LOP to
national price levels rather than to individual prices.
EVND/$ = PVN/PUS <equation 15.1>

◦ PVND: the VND price of a reference commodity basket

sold in Vietnam.
◦ PUS: the dollar price of the same basket sold in the
United States.

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The Relationship between PPP and the
Law of One Price
Difference between PPP and LOP:
◦ LOP applies to individual commodities (e.g.,
commodity i)
◦ PPP applies to the general price level.
Proponents of the PPP theory argue:
◦ Even when the law of one price is not literally true, the
economic forces behind it will help eventually to
equalize a currency’s purchasing power in all countries.

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Why is PPP very important?
Widely used to measure the equilibrium value of
currencies.
 Often used to consider whether a currency is
overvalued or undervalued.
The PPP hypothesis does not appear to be supported
by the actual data on exchange rates and prices.
However, PPP is typically employed in the literature
as a good indicator of the long-run values of
exchange rates.

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Absolute PPP and Relative PPP
Absolute PPP:
◦ Exchange rates equal relative price levels.
◦ EVND/$ = PVN/PUS

Relative PPP:
◦ The percentage change in EXR over any period equals the
difference between the percentage changes in national price
levels (inflation rate).

◦ (Et-Et-1)/Et-1 = VN , t US , t <equation 15.2>

◦  (P  P ) / P
t t t  1 t  1 <Definition of inflation rates>

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Absolute PPP and Relative PPP
(cont’d)
Absolute PPP:
◦ It makes no sense unless the two baskets whose prices are
compared in equation 15.1 are the same

Relative PPP:
◦ It makes logical sense to compare percentage changes in
EXR to inflation differences, even when countries base
their price level estimates on product baskets that differ in
coverage and composition.
◦ Relative PPP may be valid even when absolute PPP is not.

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Empirical Evidence on PPP
How well does the PPP theory explain actual
data on EXR and national price levels?
◦ All versions of the PPP theory do badly in explaining
the facts.
◦ Changes in national price levels often tell us little or
nothing about EXR movements.

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Note: “PPP exchange rate” = (Japanese Price)/(US Price)

In the short-run, PPP does not hold.

Why deviating from PPP?
 Goods must be tradable:
◦ The existence of non-traded goods and services allows systematic
deviations even from PPP.
 Commodity basket is not the same between countries.
 Trade barriers (transportation costs, restriction on trade)
do exist.
 Imperfectly competitive structures
◦ A firm sells the same product for different prices in different
markets. (Pricing-to-market).

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Why is PPP still used?

But, PPP is still widely used in a long-run

exchange rate model.  Why?

◦ See the long-run trend of the nominal exchange rate and

PPP exchange rate.

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In the long-run, PPP may be a good indicator of
actual exchange rate movements
The Economist’s Big Mac Index
See The Economist, April 26, 2003, p.67.
In1986, the Economist magazine started to conduct
an extensive survey on the prices of Big Mac at
McDonald’s restaurant throughout the world.
A McDonald’s Big Mac is produced locally to
roughly the same recipe in 118 countries.

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The Economist says....
The Big Mac Index should serve as a useful guide to
whether currencies are at their “correct” level.
Purchasing Power Parity (PPP) predicts:
◦ In the long run, exchange rate should move toward rates
that would equalize the prices of an identical basket of
goods and services in any two countries.
The Big Mac PPP is the exchange rate that would
leave burgers costing the same as in the USA.
The Economist attempts to ….

1. Calculate the implied PPP for each country.

2. Compare the implied PPP with the actual
exchange rate vis-à-vis the US dollar.
3. The test results of whether a currency is
undervalued or overvalued are reported in the last
column.

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Table: The Hamburger Standard
 1st column: local currency price of a Big Mac.
 2nd column: US dollar price of a Big Mac (by using the
actual USD exchange rate).
 3rdcolumn: Big Mac PPP (obtained by comparing the US
price with the local currency price).
 4th column: actual exchange rate vis-à-vis the US dollar.
 5thcolumn: the percentage by which the Big Mac PPP
exceeds the actual exchange rate.

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The Hamburger Standard Table
illustrates
 The currency is overvalued only in some European
countries.
 Japanese yen is undervalued by 19 percent.
 Vietnam dong is
 There are some persistent deviations from PPP.
◦ All emerging market (including East Asian) currencies are
consistently undervalued.
◦ One exception is South Korea that is exactly at its PPP.

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A Long-Run Exchange Rate Model
Based on PPP
Monetary Approach to the exchange rate:
◦ A long-run theory:
◦ Prices are assumed to be perfectly flexible.
 → (1) It maintains full employment
 → (2) PPP holds.

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The Fundamental Equation of the
Monetary Approach
Assumption (in the Forex market):
◦ In the long-run, exchange rates are determined so that
PPP holds.
◦ EVND/$= PVND/PUS <equation15.1>

Assumption: (in the domestic money market)

◦ PVN = MVN/L(RVND,YVN).
◦ PUS = MUS/L(R$,YUS).
Fundamental Equation <equation 15.4>
◦ EVND/$ = (MVN/MUS) x L(R$,YUS)/L(RVND,YVN)
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The Fundamental Equation of the
Monetary Approach (cont’d)
The monetary approach predicts:
◦ EXR is determined in the long-run by the relative supplies
of those monies and the relative real demands for them.
EVND/$ = P/P* = (M/M*) x L*(R*,Y*)/L(R,Y)
1) A permanent rise in money supply:
M →P→E (proportional long-run depreciation)
2) A rise in interest rates:
 R → L(.) → P → E (long-run depreciation → Why?)
3) A rise in domestic output:
 Y → L(.) → P → E (long-run appreciation)

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How to Explain the Paradox of
Prediction 2
Why does a rise in interest rate cause depreciation ?
(R → E ?)

Key assumption (Monetary Approach):

Price is perfectly flexible.
P = M/L(R,Y)
 If M & Y are constant, R → L(.) → P
 Since E = P/P*, then P (P* is constant) → E

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Inflation, Interest Parity, and PPP
 A permanent increase in M (level):
◦ A proportional rise in P (level), but no effect on the long-run
values of R and Y.

 What are the long-run effects of money supply growth

rate?
Mo ney Supply Price Inte re st Rate
(1) Level (2) Proportiona in price (3) No effect on the long-run
(Permanent ) level value
(1’) Growth Rate (2’) Inflation rate at the (3’) Long-run interest rate
(Permanent ) same rate

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Inflation, Interest Parity, and PPP
(cont’d)
Interest rate condition:
◦ R = R* + [E(e) – E]/E
Expected version of relative PPP:
◦ [E(e) – E]/E =  (e )   * (e )
 Where  (e ) [P(e )  P] / P

Combining both conditions:

◦ R – R* =  (e )   * (e )

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Inflation, Interest Parity, and PPP
(cont’d)
Fisher Effect:
◦ All else equal, a rise (fall) in a country’s expected inflation
rate will eventually cause an equal rise (fall) in the interest
rate.
◦ These changes would leave the real rate of return on
domestic assets (measured in terms of domestic goods and
services) unchanged.

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Inflation, Interest Parity, and PPP
(cont’d)
In the LR equilibrium (Monetary approach):
◦ A rise in the difference between home and foreign interest
rates occurs, only when expected home inflation rises
relative to expected foreign inflation.
In the SR equilibrium (sticky price approach):
◦ The interest rate can rise when the domestic money supply
falls. The sticky domestic price level leads to an excess
demand for real money balances at the initial interest rate.

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Real Exchange Rate

Real Exchange Rate (q):

◦ q¥/$ = (E¥/$ x PUS)/PJP <equation 15-6>
 A rise in q¥/$ → Real depreciation
 A fall in q¥/$ → Real appreciation

Important tool for:

◦ (1) quantifying deviations from PPP
◦ (2) analyzing macroeconomic demand and supply
conditions in open economies.

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Real Exchange Rate (cont’d)

Real Exchange Rate (q):

◦ Absolute PPP is not assumed.
◦ The same basket of commodities are not assumed in
measuring the price level.
◦ The domestic (foreign) price level will place a
relatively heavy weight on commodities produced and
consumed in the domestic (foreign) country.

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A General Model of Long-Run
Exchange Rate
 Real Exchange Rate (q):
◦ If PPP does not hold, the long-run values of real EXR depend on
demand and supply conditions in both countries.
 Two specific cases:
◦ (1) An increase (fall) in world relative demand for domestic
output → A long-run real appreciation (depreciation) of the
domestic currency.
◦ (2) A relative expansion of domestic output supply
 A fall in relative price of domestic products.
 A long-run real depreciation of the domestic currency.

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A General Model of Long-Run
Exchange Rate (cont’d)
 The equation of the general model:
◦ E¥/$ = q¥/$ x (PJP/PUS ) <equation 15-7>.
 Two specific cases:
◦ 1st term (q¥/$): captures the effect of change in relative output
supply/demand on E¥/$
◦ 2nd term (PJP/PUS): reflects the monetary approach.
◦ The difference between (15.1) and (15.7):
◦ (15.7) accounts for possible deviations from PPP by adding the
real EXR as an additional determinant.

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A General Model of Long-Run
Exchange Rate (cont’d)
 1. A shift in relative money supply levels:
◦ M (a permanent one-time increase)
◦ → No change in Y, R
◦ → No change in q
◦ → P rises in proportion to M
◦→ E

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A General Model of Long-Run
Exchange Rate (cont’d)
 2. A shift in relative M growth rate:
◦ M growth rate (a permanent increase in growth rate of domestic
money supply)
◦ → No change in Y.
◦ → Increase in long-run domestic inflation rate.
◦ → Domestic interest rate (R) increases (through the Fisher
effect)
◦ → Relative domestic money demand declines.
◦ P must increase → E
◦ q does not change

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A General Model of Long-Run
Exchange Rate (cont’d)
 3. A change in relative output demand:
◦ Demand for domestic output
◦ (1) → This effect is not covered by the monetary approach.
→ No change in P.
◦ (2) → q (q is affected by demand and supply conditions).
◦ → E (as q falls but P/P* is constant).

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A General Model of Long-Run
Exchange Rate (cont’d)
 4. A change in relative output supply:
◦ Domestic output supply (Y)
◦ (1) → This effect is not covered by the monetary approach.
→ No change in P.
◦ (2) Y → q (q is affected by demand and supply
conditions). → E
◦ (2)’ Y → L(R,Y) → P (given M) → E

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Questions
1. Under Purchasing Power Parity
a. E$/VND = PUS/PVN
b. E$/VND = PVN/PUS
c. E$/VND = PUS + PVN
d. E$/VND = PUS – PVN
e. None of the above

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Questions
2. Which of the following statements is the most accurate?
a. If PPP hold true, then the law of one price holds true for every
commodity as long as the reference baskets used to reckon different
countries’ price levels are the same
b. If the law of one price holds true for every commodity, PPP must
hold automatically
c. If the law of one price holds true for every commodity, PPP must
automatically hold as long as the reference baskets used to reckon
different countries’ price levels are the same.
d. If the law of one price not hold true for every commodity, PPP
cannot be true as long as the reference baskets used to reckon
different countries’ price levels are the same
e. None of the above.

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1. d. All of the above
25. a. Trade in goods and services
2. a. EUR has appreciated
3. b. Buy or sell foreign reserves 26. b. It takes fewer USD to buy EUR
4. d. All of the above 27. b. By buying or selling currencies
5. b. 110 JPY 28. a. Base currency
6. b. Exchanging principal and interest payments in different currencies
29. d. All of the above
7. d. ZAR
8. b. Depreciate 30. b. Demand increases
9. b. To hedge against currency risk 31. a. Exports become cheaper for foreign buyers
10. b. Political instability 32. b. Currency value determined by market forces
11. d. All of the above
33. b. It will appreciate
12. a. Exports more than it imports
13. b. Not adjusted for inflation 34. b. To stabilize the currency
14. b. GBP 35. b. They fluctuate based on supply and demand
15. a. It operates 24 hours a day 36. b. A transaction settled immediately
16. a. A fixed exchange rate system
37. d. All of the above
17. d. All of the above
18. b. The currency will likely depreciate 38. a. Spread
19. a. A foreign direct investment 39. d. All of the above
20. b. The potential for loss due to fluctuations in exchange rates 40. c. To allow market forces to dictate currency value
21. c. Floating exchange rate
41. d. All of the above
22. b. Currency depreciation
23. b. Reducing potential losses from currency fluctuations 42. b. To stabilize its currency
24. c. Exchange rate volatility 43. b. The practice of taking advantage of price differences in different markets
44. a. A reduction in the value of a currency relative to other currencies
45. a. A sudden decrease in currency value
46. b. The currency with the lower interest rate will appreciate
47. b. The framework governing how a currency's value is determined
48. d. All of the above
49. a. Appreciate during times of global uncertainty

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50. b. Higher inflation leads to higher nominal interest rates 86. d. All
51. d. Spot contracts 87. b. 1.2303/24
52. b. Exports become more expensive 88. c. International balance of payments
53. a. The ease of buying or selling a currency without affecting its price 89. b. 5%
54. a. High domestic consumption 90. c. Devaluate – 1.94%
55. a. It makes imports cheaper 91. a. 122.0028
56. a. An increase in the value of a currency relative to others 92. b. 1.2643/52
57. a. Avoid volatility in its currency value 93. a. 11.89%
58. c. High foreign direct investment 94. d. Taking place the buying and selling of different currencies
59. b. It limits a country's ability to respond to economic shocks 95. a. 7.7619
60. a. The risk of loss due to unfavorable exchange rate movements 96. a. Price of exported commodity is cheaper
61. b. Signing a EUR selling forward contract 97. d. All
62. d. Direct investment 98. b. Approximately balanced
63. c. Managed floating exchange rate 99. d. All
64. d. Transaction costs 100. d. Highest real interest rate
65. a. 205.6772/6805
66. b. 1.2643/52
67. a. Accelerated 11 points
68. c. Exchange rate differences reflect inflation differences
69. d. All
70. a. Lending and poverty alleviation
71. a. Clients accept to buy foreign currency in the future at the exchange rate determined today
72. d. International trade balance
73. b. 1.2303/24
74. d. 2 of the above sentences
75. d. Transaction costs
76. b. 8%
77. b. Approximately balanced
78. d. All are correct
79. a. 122.0028
80. a. High interest rate
81. a. Starting with 35 USD, buy 1 ounce of gold then convert gold to GBP for 20 GBP.
Convert 20 GBP to USD with 1 GBP = 1.8 USD to get 36 USD
82. c. 3.1722/25
83. b. 1.2303/24
84. a. 205.6772/6805
85. b. Use USD to buy CHF, sell CHF for GBP at bank B, sell GBP for USD at bank A
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