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### Transcript

• 2. Before we discuss PPP theory let us dig out
something from our previous knowledge
• Exchange Rate
• 3. Spot Rate
• 4. Forward Rate
• 5. Direct and Indirect
Quote
• Arbitrage
• 7. Inflation
• 8. Perfect or Efficient
markets
• 9. We will try to find the answers for the following?
• Can we predict the changes in exchange rate?
• 10. Does inflation affect exchange rate?
• 11. If it does, how?
• 12. Does interest rate affect exchange rate?
• 13. If it does, how?
• 14. How can we arrive at a more proper and actual exchange rate?
• Theories of exchange rate determination
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
• 16. 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..
• 17. Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P\$
S€/\$ = spot exchange rate
• Example:
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€
= 1.2017 \$/€ x 3.45 € = \$4.1676
P€ = S€/\$  P\$
• 18. 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
• 19. Absolute PPP
Law of one price extended to
If the price of the
rises relative to the
price in Euros, the US
dollar depreciates
• 20. 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?
• 21. 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
• 22. 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
• 23. Deviations from absolute PPP
• 24. Big Mac and PPP