How can we arrive at a more proper and actual exchange rate?
Theories of exchange rate determination
Purchasing Power Parity The PPP theory focuses on the inflation – exchange rate relationships. If the law of one price holds for all goods and services, we can obtain the theory of PPP. LAW OF ONE PRICE
Law Of One Price Law of one price states “ In an efficient all identical goods must have only one price” Identical goods should sell at identical prices in different markets If not, arbitrage opportunities exist Assumes that there will be no shipping costs, tariffs, taxes….etc. Relates to a particular commodity, security, asset etc..
Example Price of wheat in France (per bushel): P€ Price of wheat in U.S. (per bushel): P$ S€/$ = spot exchange rate
Price of wheat in France per bushel (p€) = 3.45 € Price of wheat in U.S. per bushel (p$) = $4.15 S€/$ = 0.8313 (s$/€ = 1.2028) Dollar equivalent price of wheat in France = s$/€ x p€ = 1.2028 $/€ x 3.45 € = $4.1496 P€ = S€/$ P$
Historical back drop A Swedish economist Gustav Cassel introduced the PPP theory in 1920s Countries like Germany, Hungary and Soviet Union experienced hyperinflation in those years due to World War I The purchasing power of these currencies declined sharply The currencies depreciated sharply against more stable currencies like the US dollar
Absolute PPP Law of one price extended to a basket of goods If the price of the basket in the U.S. rises relative to the price in Euros, the US dollar depreciates
Have a look If the price of the basket in the U.S. rises relative to the price in Euros, over a period of three days May 21 : s€/$ = P€ / PUS = 1235.75 € / $1482.07 = 0.8338 €/$ May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$ Has the US dollar appreciated or depreciated?
Mathematically , Absolute PPP postulates that Pais the general price level in country A Pbis the general price level in country B sa/bis the exchange rate between currency of country A and currency of country B sa/b = Pa / Pb
Statement The absolute PPP postulates that the equilibrium exchange rate between currencies of two countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar products of two countries should be equal when measured in a common currency as per the absolute version of PPP theory