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IBUS 302: International Finance

In this topic of IBUS 302: International Finance, we delve into Purchasing Power Parity (PPP) and its significance in comparing different currencies. The session led by Lawrence Schrenk aims to explain the rationale behind PPP. Students will learn how to calculate the requirements for absolute purchasing power parity, enhancing their understanding of how exchange rates adjust based on price levels in different countries. This foundational knowledge is crucial for understanding international economic relations and currency valuation.

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IBUS 302: International Finance

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  1. IBUS 302: International Finance

    Topic 8–Purchasing Power Parity Lawrence Schrenk, Instructor
  2. Learning Objectives Explain the rationale for purchasing power parity (PPP). ▪ Calculate the requirements for absolute purchasing power parity. Calculate the requirements for relative purchasing power parity.▪

  3. Purchasing Power Parity (PPP)

  4. Purchasing Power Parity (PPP) Law of One Price Identical goods should have the same price. Purchasing Power Parity FX rates adjust to equalize purchasing power across countries (so the law of one price holds). FX rates will not affect international competitive (since the law of one price holds).
  5. Absolute Purchasing Power Parity: Example PPP: If you can buy a basket of goods (A) costs in the US for $100, you should be able to buy the same basket (A) in Germany for $100. If the basket cost €75, Then this would only be true if SPPP is the spot rate predicted by absolute PPP.
  6. Absolute Purchasing Power Parity The ‘absolute’ version of PPP connects FX rates (SPPP) to price levels (Px). FX rates are determined by price levels. This just ‘formalizes’ the previous example: Px is the price level for currency x.
  7. Absolute Purchasing Power Parity Example Does absolute PPP hold, if... Cost of DVD in US $16.00 Cost of DVD in Canada C$18.40 S($/C$) 0.9000 If not, what would be S($/C$) if PPP holds? If... Cost of DVD in US $17.50 Cost of DVD in Canada C$19.20 S($/C$) 0.9115 If not, what would be S($/C$) if PPP holds?
  8. Relative Purchasing Power Parity The ‘relative’ version of PPP connects changes FX rates, i.e., forward rates (F), to changes in price levels (Px). A change in FX rates is determined by inflation, i.e., a change in price levels. NOTE: PPP refers to relative purchasing power parity unless noted otherwise.
  9. Inflation Estimating Inflation Consumer Price Index (CPI) Source CPI2005= 195.3 CPI2006 = 201.6 Inflation = Inflation Differences (October 2008) Source
  10. Relative Purchasing Power Parity Example Data A can of soda Canadian costs C$1.00 S($/C$) = 0.9231 (so S($C/$) = 1.0833) E(p$) = 5% E(pC$) = 3% Today If you have $100, you can buy 108.3 cans.
  11. Relative Purchasing Power Parity Example (cont’d) Next Year If p$ = 5%, today’s dollar will be worth $1.05 If pC$ = 3%, each can will cost C$1.03. If relative PPP, then FPPP ($/C$) must still allow you to buy 108.3 cans. So FPPP is the forward rate predicted by PPP
  12. Relative Purchasing Power Parity The ‘relative’ version of PPP connects percentagechangesin FX rates (ePPP) to inflation (px), i.e., percentagechangesin price level, not absolute price levels. If relative PPP holds, then ePPPmust be the percentage change in the FX rate. ePPP is the percentage change in F predicted by PPP; the equilibrium percentage change in F.
  13. Relative Purchasing Power Parity ePPP is the percentage change in F predicted by PPP. Calculating FPPP: FPPP($/x) = S($/x) x (1 + e) If S($/C$) = 0.8161 and ePPP = 0.02, then FPPP($/C$) = 0.8161 x 1.02 = 0.8324 NOTE: Do not us the approximation formula: ePPP ≈ p$ - px
  14. Key Idea: Differentials Forward rates are determined by differentials in inflation (p). If expected inflation is equal, p$=p€, FPPP($/€) = S($/€) American Terms FPPP (€/$) = S(€/$) European Terms If expected inflation is not equal, p$≠p€, FPPP ($/€) ≠ S($/€) American Terms FPPP (€/$) ≠ S(€/$) European Terms
  15. Relative Purchasing Power Parity Data S($/C$) = 0.9231 (so S($C/$) = 1.0833) E(p$) = 5% E(pC$) = 3% So if relative PPP holds
  16. IRP versus PPP
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