Absolute purchasing power parity If the law of one price were true for all goods and services,the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies,we could determine the "real"or PPP exchange rate that should exist if markets were efficient. This is the absolute version of the PPP theory
Absolute purchasing power parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the “real” or PPP exchange rate that should exist if markets were efficient. This is the absolute version of the PPP theory
Absolute purchasing power parity the Big Mac Index Assuming that the Big Mac is identical in all countries,it serves as a comparison point as to whether or not currencies are trading at market prices. Big Mac in China costs Yuan11,while the same Big Mac in the US costs $3.41. The actual exchange rate was Yuan7.60/$at the time. The price of a Big Mac in China in US dollars: Yuan11/(Yuan7.60/s)=$1.45
Absolute purchasing power parity the Big Mac Index Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices. Big Mac in China costs Yuan11, while the same Big Mac in the US costs $3.41. The actual exchange rate was Yuan7.60/$ at the time. The price of a Big Mac in China in US dollars: Yuan11/ ( Yuan7.60/$ ) = $1.45
Absolute purchasing power parity the Big Mac Index The implied PPP exchange rate: Yuan11/$3.41=Yuan3.23/$ Compare the implied PPP exchange rate with the actual exchange rate: (Yuan3.23/$-Yuan7.60/$)Yuan7.60/$=-58%
Absolute purchasing power parity the Big Mac Index The implied PPP exchange rate: Yuan11/$3.41= Yuan3.23/$ Compare the implied PPP exchange rate with the actual exchange rate: ( Yuan3.23/$ -Yuan7.60/$ ) /Yuan7.60/$ =-58%
Relative purchasing power parity The relative PPP explains the changes in exchanges rates over time rather than the absolute levels of exchange rates. The change in the exchange rate is (approximately)determined by the difference in inflation rates. If Japan has a inflation of 4%lower than the US,the relative PPP predicts that the Yen will appreciate by 4%per annum to the US Dollar
Relative purchasing power parity The relative PPP explains the changes in exchanges rates over time rather than the absolute levels of exchange rates. The change in the exchange rate is (approximately) determined by the difference in inflation rates. If Japan has a inflation of 4% lower than the US, the relative PPP predicts that the Yen will appreciate by 4% per annum to the US Dollar
Exhibit 6.2 Relative Purchasing Power Parity (PPP) Percentage change in the spot exchange rate for foreign 4 P currency 3 PPP Line 2 1 5 -4-3 -2 -1 1 23456 -1 Percentage difference in expected rates of -2 inflation(foreign relative to home country) 4
Exhibit 6.2 Relative Purchasing Power Parity (PPP)