Purchasing Power Parity1

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  • This means that for every dollar spent on Pen in the United States, 45 Rs would have to be spent in India to obtain the same quantity and quality - or, in other words, the same volume – of Pen
  • Purchasing Power Parity1

    1. 1. Purchasing Power Parity<br />
    2. 2. What are PPPs?<br />The Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries<br /> For example:<br /> Price of Pen = 2 $ (U.S)<br /> Price of Pen = 90 Rs<br /> then, By PPP, 1$= 45 Rs<br />
    3. 3. What are the major uses of PPPs?<br />First step in inter-country comparisons in real terms of GDP <br />To compare economic data between countries that is expressed in units of national currency<br />This Can also be achieved using<br /><ul><li> Exchange rate system through forces of demand and supply</li></li></ul><li>X-rate by Demand and Supply <br />Merits<br />X-rates are easily understood being<br /> determined by the demand for &<br /> the supply of currencies <br />X-rates are easily observed, cover all<br /> countries, readily available<br />(newspapers) & timely (daily rates)<br />Demerits<br />X-rate converted GDPs are not<br /> consistent over time<br />Exchange rates are affected by the relative prices of tradable goods and by factors such as interest rates, financial flows etc<br />
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    5. 5.
    6. 6. PPP & X-rate<br />Difference between PPP and X-rate indicates Prices of product is understated or overstated<br />Difference between PPP and X-rate do not Indicates particular currency is undervalued or overvalued<br />
    7. 7. PPP and X-rate<br />PPP useful when comparing output levels or productivity levels between countries<br />X-rate based comparisons are more appropriate in others<br /> For ex- if an analyst wanted to work out how much could be imported with the proceeds from a particular level of exports then it would be necessary to use exchange rates rather than PPPs.<br />Ideally in long run X-rate converges to PPP rate<br />
    8. 8. PPP Equilibrium Story<br />
    9. 9. PPP and X-rate in Long Run<br />Market <br />Basket<br />Ratio<br />Year<br />
    10. 10.
    11. 11. GDP-purchasing power parity 2009 Country Ranks <br />
    12. 12. How are PPPs calculated for GDP?<br />Two stages<br />At the product group level<br /> CB = P1Q1 + P2Q2 + P3Q3 + ... + PnQn<br /> PPP for Product group N between two country<br /> = (CB)country1/(CB)Country2 <br />At the GDP or any aggregate levels<br /> X=[(PPP PG1)*W1 + ------- +(PPP PG N)*Wn] <br /> PPP GDP of two country = X country1/ X country2 <br />Prices used in the calculation of PPPs are market Prices<br />
    13. 13. Gerschenkron effect arises when aggregation methods that use either a reference price structure or a reference volume structure to compare countries.<br />Country reports prices that are not representative of its consumption patterns<br />Situations when biases arise in PPPs<br />
    14. 14. Interest rate Pairity<br />The relationship between the exchange rates and interest rates, is called Interest rate parity or covered interest arbitrage<br />Interest rate parity (IRP) holds when the rate of return on one currency deposits is just equal to the expected rate of return on other currency deposits.<br />
    15. 15. Covered interest rate Parity<br />Risk of foreign exchange is covered by entering into forward contract<br />

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