Purchasing Power Parity: Understanding Currency Valuation

1. Chapter 14 Prices and Exchange Rates: Purchasing Power Parity

2. Topics to be Covered • Purchasing Power Parity (PPP) • Absolute PPP • Law of One Price • Relative PPP • Deviations from PPP • Overvalued vs. Undervalued Currencies • Real Exchange Rate

3. Purchasing Power Parity • Purchasing Power Parity (PPP)—the relationship between prices and exchange rates which asserts that as prices change internationally, exchange rates must also change to keep prices measured in a common currency equal across countries.

4. Two Views of PPP • Absolute Purchasing Power Parity • Relative Purchasing Power Parity

5. Absolute PPP • The Absolute Purchasing Power Parity relation is: where P is the domestic price index, PF the foreign price index, and E is the spot exchange rate (domestic currency units per unit of the foreign currency).

6. Absolute PPP (cont.) • Absolute PPP indicates that the exchange rate between two currencies is equal to the ratio of the two countries’ price indexes. • The exchange rate is a nominal value, that is, its value is dependent on current price levels. • A problem arises when the national price indexes are not comparable in terms of product coverage and base year used.

7. Law of One Price • The Absolute PPP equation can be rewritten as: where the domestic price level is equal to the exchange rate times the foreign price level. This is called the law of one price, indicating that similar goods sell for the same price worldwide.

8. Problems with Law of One Price • The more homogeneous goods are, the more the law of one price is expected to hold. • There are obstacles to equalization of product prices across countries, including differentiated products and costly information.

9. Problems with Absolute PPP • Absolute PPP may not hold due to: • Transportation costs and tariffs are present. • National price indexes capture the prices of goods that are not traded internationally. • Changes in the exchange rate may be due to real rather than nominal economic events. Real events, such as relative price changes resulting from a poor harvest, may cause deviations from absolute PPP as the exchange rate changes, even if the price indexes remain constant.

10. Relative Purchasing Power Parity • Relative PPP is said to hold if: where a caret (^) over a variable indicates percentage change. Relative PPP states that the percentage change in the exchange rate is equal to the percentage change in the domestic price level minus the percentage change in the foreign price level.

11. Relative PPP (cont.) • Alternatively, relative PPP states that the percentage change in the exchange rate is equal to the inflation differential between the domestic and foreign countries. • If absolute PPP holds, then relative PPP also holds. If absolute PPP does not hold, relative PPP may still hold. • Real events which cause relative price changes are often random or unexpected.

12. Time, Inflation, and PPP • Some studies have found that PPP holds better for high-inflation countries. • Studies have found that PPP holds well in the long run.

13. PPP on a Monthly vs. Annual Basis • Refer to Figure 14.1 • The exchange rates are more variable than the inflation differentials. • Deviations from PPP are more apparent for monthly than for annual data.

14. FIGURE 14.1 U.S.–Japan Purchasing Power Parity

15. Reasons for Deviations from PPP • The law of one price does not apply to differentiated products or to globally non-traded goods. • Prices may differ due to freight costs or tariffs. • Relative price changes may result from real economic events such as changing tastes, bad weather, or government policy. • Since people in different countries consume different goods, national price indexes may not be comparable.

16. Reasons for Deviations from PPP (cont.) • PPP is not a theory of exchange rate determination. Both prices and exchange rates are endogenous variables determined by other given factors such as bad weather or government policy (exogenous variables). • Unexpected information or news (e.g., Federal Reserve monetary policy announcement) may affect both exchange rates and prices (refer to Figure 14.2).

17. FIGURE 14.2 Shifts in the Foreign-Exchange Market and Deviations from PPP

18. Reasons for Deviations from PPP (cont.) • Another reason for deviations from PPP is that international trade transactions involve time lags between order and delivery.

19. Summary: Three Sources of Deviations from PPP • Factors that suggest permanent deviations (e.g., shipping costs and tariffs). • Factors that would produce temporary deviations (differential speed of adjustment between financial asset markets and goods markets, or relative price changes).

20. Summary: Three Sources of Deviations from PPP (cont.) • Factors that cause the appearance of deviations where none actually exist (comparing current exchange rates with prices set in the past, or using national price indexes when countries consume different baskets of goods).

21. “Overvalued” vs. “Undervalued” Currency • Overvalued currency—a currency worth more than the PPP value. • Undervalued currency—a currency worth less than the PPP value. • Refer to Global Insights: Big Mac PPP

22. Real Exchange Rate • The real exchange rate is measured as: that is, the real exchange rate is equal to the nominal exchange rate divided by the ratio of the domestic and foreign price indexes.