Purchasing Power Parity

Bill Reese

International Finance

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Learning Objectives

In this unit we will learn: What the law of one price is Why absolute PPP doesn’t always hold What relative PPP is About the International Fisher Effect

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Law of One Price

The law of one price The same good will cost the same everywhere No arbitrage opportunities Can’t buy diamonds in Canada and sell them in

U.S.

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Law of One Price

PD = Sdirect x PF

The price of a good domestically is the same as its price on a foreign market, adjusted for the spot direct exchange rate

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Law of One Price

Absolute Purchasing Power Parity Often doesn’t hold Presumes frictionless markets

Transportation costs Taxes Non-identical goods

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CountryBigMac Price XR

in Local Currency in US dollars

United States $ 3.41 3.41 1Argentina Peso 8.25 2.6076 3.1638Australia A$ 3.45 3.1143 1.1078Brazil Real 6.9 3.9603 1.7423Britain £ 1.99 3.9422 0.5048Canada C$ 3.88 3.7828 1.0257Chile Peso 1565 3.4801 449.7China Tuan 11 1.5575 7.0625Colombia Peso 6900 3.7262 1851.76Denmark Dkr 27.75 5.7283 4.8444Eygpt Pound 9.54 1.7006 5.6098Euro area € 3.06 4.712 0.6494Hong Kong HK$ 12 1.5425 7.7798Hungary Forint 600 3.5877 167.236Iceland Kronur 469 5.929 79.1033Japan ¥ 280 2.7989 100.038Malaysia Ringgit 5.5 1.6984 3.2383Mexico Peso 29 2.7046 10.7223New Zealand NZ$ 4.6 3.6447 1.2621Norway Kroner 40 7.5709 5.2834Pakistan Rupee 140 2.2526 62.1508Paraguay Guarani 10500 2.2491 4668.6Philippines Peso 85 2.033 41.8106Poland Zloty 6.9 3.0054 2.2959Russia Rouble 52 2.1826 23.8243Saudi Arabia Riyal 9 2.3962 3.756Singapore S$ 3.95 2.8413 1.3902South Africa Rand 15.5 1.898 8.1664South Korea Won 2900 2.8197 1028.49Sweden Skr 33 5.3882 6.1245Switzerland SFr 6.3 6.1941 1.0171Taiwan NT$ 75 2.4888 30.1354Thailand Baht 62 1.9578 31.6678Uruguay Peso 62 2.9424 21.071Venezuela Bolivar 7400 3.4393 2151.61

Law of One Price

Can you buy a load of Big Macs in China, sell them in Norway, and earn an arbitrage profit?

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Law of One Price

Relative Purchasing Power Parity Changes in prices Not absolute prices Relative inflation or deflation Usually holds

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Relative PPP

(1 + ΠD) = St+1 = 1+ΔSD/F (1 + ΠF) St

Countries with higher inflation should see their currency depreciate

Inflation expectations gives us XR expectation

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Relative PPP Example:

• Expected inflation rate in U.S. next year is 3.0%• Expected inflation rate in Mexico next year is 5.0%• Current spot rate

2.7 pesos/$ = .37 $/peso

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Relative PPP

(1 + .03) = St+1 = 1+ΔS$/P (1 + .05) .37

1+ΔS$/P = 0.981 → ΔS$/P= -1.9% St+1 = .363 $/peso =2.755 peso/$

Peso expected to depreciate by 1.9% Dollar expected to appreciate by 1.9%

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International Fisher Effect

Fisher effect 1 + real rate = 1 + nominal rate 1 + inflation rate 100 →107 100 →103 (1.07/1.03) – 1 = 3.88%

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International Fisher Effect

International Fisher Effect• Investors concerned with real rate (gain in

purchasing power) – invest where it is highest• Real rates will equalize across countries

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International Fisher Effect

International Fisher Effect• Differences in nominal rates across countries are

due to differences in inflation expectations• Real rates will equalize across countries

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International Fisher Effect

International Fisher Effect Currency values will Δ in amount equal to, but in

opposite direction from difference in nominal interest rates

If nominal rates only vary by inflation expectations

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International Fisher Effect

International Fisher Effect• Often doesn’t hold• Investors will look to make money in “carry trade”

by borrowing in currency with lower rate and investing in currency with higher rate

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