International Finance

ECN4183 International Finance 07 Purchasing Power Parity (PPP) Daniels and VanHoose 3e CHAPTER 2 Madura 8e CHAPTER 8

Purchasing Power Parity (PPP) • Purchasing Power Parity or Law of One Price • A condition that states that if international arbitrage is unhindered, the price of a good or service in one nation should be the same as the exchange rate adjusted price of the same good or service in another nation. • There are two version of PPP • Absolute Purchasing Power Parity • Relative Purchasing Power Parity

1. Absolute PPP • Absolute PPP states that, ignoring transportation costs, tax differential and trade restrictions, traded homogeneous goods & services should have the same price in 2 countries after converting their prices into a common currency. • The law of one price simply says that the same good in different competitive markets must sell for the same price, • when transportation costs and barriers between those markets are not important.

Example • Suppose the market price of a coat is $ 450 in New York. • The market price of the same coat in London is £300. • Thus absolute PPP would imply that the dollar equivalent exchange rate of the pound should be 1.5 $/£ as (£300 x 1.5 = $450). • Under absolute PPP or Law of one price, the coat has the same price in London as it does in New York after adjusting for the exchange rate.

Arbitrage and PPP • From the previous example: • If the market exchange rate is not 1.5 £/$, then an arbitrage opportunity exists. • Suppose the exchange rate is 1.6 £/$. • The dollar price of the coat in London is £300 x 1.6 £/$ = $480. • The astute arbitrager would be able to • buy a coat in New York for $450; • take it to London and sell it for £300; • Exchange the £300 for $480 on the foreign exchange market • Earn a profit of $30, ignoring transaction and transportation costs.

Formulating Absolute PPP • Absolute PPP is expressed as P = P*×S where P is the domestic price, P* is the foreign price, and S is the spot rate (expressed as domestic to foreign currency) • In words, the domestic price level should be equal to the foreign price level times the spot exchange rate. • Often it is rearranged as: S = P/P* • If absolute PPP holds, then the bilateral spot exchange rate should equal to the ratio of the price levels of the 2 nations.

2. Relative PPP • Absolute PPP deals with absolute price levels. • Relative PPP is a weaker version of PPP, as it addresses price changes as opposed to absolute price levels. %S = %P - %P* %S =  - * where  is the inflation rate. • In words, domestic inflation less foreign inflation should equal the change in the spot rate. • The appreciation or depreciation of a currency is given by the difference between the 2 nations’ inflation rates • This is the version that economists would test.

Example • Under the Relative PPP, the rate of appreciation of the US-dollar-per-currency is supposed to be %ΔS = 8.80 –9.13 = -0.33% (negative sign = appreciation) • Relative PPP implies that the higher inflation country should see its currency depreciate.

Graphic Analysis of PPP The points on the PPP line suggest that • given an inflation differential between the home and the foreign country of X%, • the foreign currency should adjust by X% due to that inflation differential. 8.1

Graphic Analysis of PPP (cont.) • Point A represents an example in which the U.S. (considered the home country) and British inflation rates were assumed to be 9% and 5%, so that Ih – If = 4%. • This led to anticipated appreciation in the British pound of 4% 8.1 • Point B: U.S. and foreign inflation rates are 1% and 6%, so that Ih – If = -5%. • This leads to anticipated depreciation on the foreign currency by 5%.

PPP Line • If the exchange rate does respond to inflation differentials as PPP theory suggests, the actual points should lie on or close to the PPP line. • If the exchange rate does not move as PPP theory suggests, there is a disparityin the purchasing power of the 2 currencies.

Purchasing Power Disparity • Point C in Exhibit 8.2 represents a situation were home inflation (Ih ) exceeds foreign inflation (If ) by 4%. • Yet, the foreign currency appreciated by only 1%. • Consequently, purchasing power disparity exists. • Home country consumer’s purchasing power for foreign goods has became more favorable.

Identifying Disparity in Purchasing Power 8.2

Purchasing Power Disparity • Disparity in purchasing power should exist only in short run. • Over time, as the home country consumers take advantage of the disparity by purchasing more foreign goods, • upward pressure on the foreign currency’s value will cause point C to move toward the PPP line. • All points to the left of ( or above) the PPP line represent more favorable purchasing power of foreign goods than for home goods.

Shortcomings of PPP • Reasons why PPP may not be accurate: the law of one price may not hold because of • Trade barriers and non-tradable products • Imperfect competition • Differences in measures of average prices for baskets of goods and services

Shortcomings of PPP (cont.) • Trade barriers and non-tradable products • Transport costs and governmental trade restrictions make trade expensive and in some cases create non-tradable goods or services. • Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts). • The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value. • One price need not hold in 2 markets.

Shortcomings of PPP (cont.) • Imperfect competition may result in price discrimination: “pricing to market.” • A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay. • One price need not hold in 2 markets. • Monopolistic/Oligopolisticpractices

Shortcomings of PPP (cont.) • Differences in the measure of average prices for goods and services / Different commodity baskets • levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured. • Because measures of groups of goods and services are different, the measure of their average prices need not be the same. • One price need not hold in 2 markets.

International Finance