Purchasing Power Parity - Purchasing Power Parity(PPP PPP =...

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Purchasing Power Parity (PPP) PPP = relationship between exchange rates and prices of goods in different countries Simple theory/model of exchange rate determination (since 200+ years, from Sweden) 3 goals: o Provides baseline forecast for future exchange rate changes o Fundamental role in corporate decision making (location of plants, pricing products, hedging) o Useful in assessing cost-of-living differences across countries Comparison of purchasing power of money within a country to purchasing power of that money spent in another country Law of One Price (LOP) Basic principle of PPP can be viewed as generalization of LOP LOP = basic parity relationship that arises in commodity markets “In the absence of frictions such as shipping costs, tariffs, and other restrictions to trade, the price of a commodity when expressed in a common currency, is the SAME in every country.” P Dom A = S( Dom/For ).P For A where P Dom A is the domestic price of good A, P For A is the foreign price of good A, and S(Dom/For) is the spot exchange rate (price of the foreign currency expressed in terms of units of domestic currency). Commodity arbitrage = driving force underpinning the LOP Involves either buying commodity in cheapest country if prices are different, or buying commodity in cheaper country and selling it in dearer country Drive up commodity price in lower-priced country and reduce price in more- expensive market
If LOP does not hold, buying decisions (commodity arbitrage) help restore equality LOP EXAMPLE: For example, suppose P US wheat =USD 4.00, P Aus wheat =AUD 6.00 and S(USD/AUD)= USD 0.7000. Then the US dollar price of wheat in Australia is USD 4.20 (=0.7000x6.00). Price of US wheat < USD price of Australian wheat Wheat buyers will buy wheat from the US and not Australia, forcing up the price of wheat in the US and forcing down the Australian price until LOP as given by equation(1) is satisfied. LOP: US dollar price of commodity in US = AUS dollar price of commodity in Australia x Spot exchange rate (US/AUS) PPP in Absolute Form If LOP were to hold for each and every good, and we computed cost of same basket of goods and services in AUS and US, we expect: P US = S(USD/AUD).P AUS Can be rearranged to give the spot exchange rate in terms of relative costs of goods: S(USD/AUD) = P US P AUS = P US / P AUS APPP EXAMPLE: 2
For example, if P US = USD 1000 and P AUS = AUD 1500, then Absolute PPP would stipulate an equilibrium spot exchange rate given by S(USD/AUD) = 0.6667 (= USD1000/AUD1500). Absolute PPP = simple theory of exchange rate determination. Equilibrium spot exchange rate determined by countries’ respective price levels. Nominal price = monetary value of typical bundle of consumption goods Price level = nominal price level of country’s basket of goods Inflation = when price level is rising Deflation = when price level is falling PP = inverse of price level Calculating annual inflation: where (t+1) = (P(t+1) – P(t))/P(t) Calculating cumulative inflation: where N=last-base year Internal purchasing power = the amount of goods and services that can be purchased with $1 in the US 3

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