Chapter5Models of theforeignexchangedetermination
Chapter 5 Models of the foreign exchange determination
5.1PurchasingpowerparityThe theory linking inflation and exchangerate movements is knownaspurchasingpowerparity (PPP)
5.1 Purchasing power parity The theory linking inflation and exchange rate movements is known as purchasing power parity (PPP)
ThelawofonepriceoThetheoryofPPpisbasedonthelawofoneprice (LOP).The law of one price states that identicalcommodities or goods must have the sameprice in all markets
The law of one price The theory of PPP is based on the law of one price (LOP). The law of one price states that identical commodities or goods must have the same price in all markets
Absolute andrelativePPPPGBp(O) = Pusp(O)S。(GBP / USD)This relation represents the absolute form ofPPP andis veryrestrictive
Absolute and relative PPP 0 (0) (0) ( / ) P P S GBP USD GBP USD = This relation represents the absolute form of PPP and is very restrictive
R(0)S,(GBP / USD)PusD (t)S.(GBP / USD)(0)TherelativeformofPPP,morecommonlyused today,is less restrictive than theabsoluteform.o Itstatesthat incomparisonto aperiodwhenexchangerateswereineguilibriumchangesintheratioof domesticto foreignprices indicatethe appropriate adjustmentin the exchangerate
0 ( ) ( / ) (0) ( / ) ( ) (0) GBP t GBP USD USD P t S GBP USD P S GBP USD P t P = The relative form of PPP, more commonly used today, is less restrictive than the absolute form. It states that in comparison to a period when exchange rates were in equilibrium, changes in the ratio of domestic to foreign prices indicate the appropriate adjustment in the exchange rate