Multinational Finance Final Exam!!! Chapter 8 Purchasing Power Parity (PPP) · Relationship between relative inflation rates (I) and exchange rates (e) · When a country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the high-inflation country’s currency. · Purchasing power parity (PPP) theory attempts to quantify this inflation – exchange rate relationship. · Absolute Form of PPP : without international barriers, consumers shift their demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal when measured in common currency. o Prices of the same basket of products in two different countries should be equal when measured in common currency. o If not equal, consumers will shift purchases to wherever products are cheaper until the purchasing power is equal. · Relative Form of PPP : Due to market imperfections, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency. However, the rate of change in prices should be somewhat similar when measured in common currency as long as transportation costs and trade barriers are unchanged. o two identical products in two different countries do not have the same price but have similar rate of change · Rationale: Exchange rate adjustment is necessary for the relative purchasing power to be the same whether buying products locally or from another country. o If not equal, consumers will shift purchases to wherever products are cheaper until the purchasing power is equal. o Example: Suppose U.S. inflation > U.K. inflation. U.S. imports from U.K. increase and U.S. exports to U.K. decrease causing upward pressure is placed on the £. This shift in consumption and the £’s appreciation will continue until · 1) in the U.S.: price U.K. goods ≥ price U.S. goods · 2) in the U.K.: price U.S. goods ≤ price U.K. goods · Scenarios: o Relatively high local inflation imports increase, exports decrease local currency should depreciate by some degree as inflation differential o Relatively low local inflation imports decrease, exports increase local currency should appreciate by some degree as inflation differential o Local and foreign inflation rate are similar no impact of inflation on import or export volume local currency’s value not affected by inflation · Why purchasing power parity does not work: o Confounding effects : Change in currency’s spot rate is also influenced by change in differential inflation, differential interest rates, differential income level, govt. controls, and expectations of future exchange rates; not just purchasing power
o No substitutes for traded goods, if the product is not offered in both countries, the consumer cannot switch · Testing the PPP o Apply regression analysis to historical exchange rates and inflation differentials o Then apply t-tests to the regression coefficients. (Test for a0 = 0 and a1 = 1.) o
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