Chapter_15 - Chapter 15: Price Levels and the Exchange Rate...

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Chapter 15: Price Levels and the Exchange Rate in the Long Run Purchasing Power Parity (PPP) Purchasing power parity: the idea that exchange rates are determined by the amount of different currencies required to purchase a representative bundle of goods. In other words, it is the concept that explains movements in the exchange rate between two currencies by changes in the countries’ price levels. When PPP holds, an individual will be indifferent in buying an identical good at home or abroad because it will cost the same amount of money in different countries when measured in the same currency. Absolute Purchasing Power Parity (APPP) It is the form of PPP stated in terms of levels of prices and level of exchange rate . More formally, APPP tells us that in the absence of frictions such as transportation costs, tariffs and others, it should cost the same amount of money to purchase an identical basket of goods in different countries when expressed in the same currency In notation form, APPP can be expressed as: Let: P = # of DC per basket of goods at home P* = # of FC per basket goods abroad PPP implies: P = E DC/FC × P* * P P E = Relative Purchasing Power Parity (RPPP) It is the form of PPP stated in terms of inflation rates and changes in exchange rates. RPPP tells that percentage change in the exchange rate between two currencies over any period equals to the inflation rate differentials between the two countries. In notation form, RPPP can be expressed as: * π π E E e E - = - ECMC61 – Chapter 15 1
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Implication : RPPP tells us that the rate of a country’s currency depreciates by the excess of its inflation over that of another country. Refer to page 385 of the text for formal derivation of RPPP.
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Chapter_15 - Chapter 15: Price Levels and the Exchange Rate...

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