Week 4 - Purchasing Power Parity and Exchange Rates Flashcards
What is the goal of the Purchasing Power Parity (PPP) theory? (2)
- To explain the relationship between exchange rates and price levels
- Suggests that the exchange rate between two currencies should equal the ratio of the countries’ price levels
What is the Law of One Price (LOOP)? (2)
- Identical goods, when priced in a common currency, should have the same price in different countries
- If they don’t arbitrage can occur
How does arbitrage work under the Law of One Price? (3)
- If goods are cheaper in one country than another, arbitrageurs will buy the cheaper goods and sell them in the more expensive country
- This drives up prices in the cheaper country and drives prices down in the more expensive country
- This eventually leads to an exchange rate fluctuation
What does the PPP formula for exchange rates look like? (3)
Sppp = Pd / Pf
- Sppp - exchange rate
- Pd - domestic price level
- Pf - foreign price level
What is absolute PPP? (2)
- Asserts that the exchange rate between two currencies is the ratio of the price levels in the two countries
- If absolute PPP holds, a currency should have the same purchasing power in both countries
How can you calculate the exchange rate under Absolute PPP? (2)
- The exchange rate is calculated as the ratio of the price levels in two countries
- When UK price level is 750 GBP and Swiss is 1000 CHF, exchange rate: Sppp = 750/1000
What is the real exchange rate? (3)
- Measures the relative competitiveness of domestic and foreign goods
- Rt = St x (Pf/Pd)
- St - nominal exchange rate, Pf - foreign price level, Pd - domestic price level
What is Relative PPP? (2)
- Accounts for changes in price levels over time between two countries
- Suggests that the percentage change in exchange rates between two countries will equal the inflation differential between them
What is the formula for Relative PPP? (2)
- ef = (1+Ih) / (1+If) - 1
- ef - percentage change in the exchange rate, Ih - home country inflation rate, If - foreign country inflation rate
What are the limitations of Absolute PPP? (4)
- Assumes no trade frictions, such as tariffs or transaction costs
- Assumes perfect competition
- Doesn’t account for non-traded goods or services
- Assumes price levels are directly comparable between countries
What is the Big Mac Index and what significance does it have to PPP? (2)
- Compares the price of a Big Mac in different countries to measure the deviation from absolute PPP
- Highlights how the cost of living can differ across countries
What is price discrimination in the context of PPP?
Occurs when producers charge different prices for the same good in different markets based on factors like income levels and demand elasticity, leading to deviations from PPP
What is the International Fisher Effect?
Suggests that the expected change in the exchange rate between two currencies over time is equal to the difference in nominal interest rates between the two countries
How is the IFE related to interest rates? (2)
- Implies that higher interest rates in one country will be offset by expected currency depreciation
- Expected returns on investments across countries are equalised once adjusted for exchange rate changes
What is the formula for the IFE? (2)
ef = (1 + id x (T/360)) / (1 + if x (T/360) - 1
- ef - expected change in exchange rate, id - domestic interest rate, if - foreign interest rate, T - time period
What assumptions does the IFE rely on? (4)
- No barriers to capital mobility
- No country risk or default risk
- No preference for domestic investments
- Equal returns once adjusted for currency fluctuations
How can the IFE be tested?
Using regression models on historical data comparing interest rate differentials and exchange rate movements to determine if the expected relationship holds in practice
