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1. 1. Purchasing Power Parity<br />
2. 2. Before we discuss PPP theory let us dig out <br /> something from our previous knowledge<br /><ul><li>Exchange Rate
3. 3. Spot Rate
4. 4. Forward Rate
5. 5. Direct and Indirect</li></ul> Quote<br /><ul><li>Arbitrage
7. 7. Inflation
8. 8. Perfect or Efficient </li></ul> markets<br />
9. 9. We will try to find the answers for the following?<br /><ul><li>Can we predict the changes in exchange rate?
10. 10. Does inflation affect exchange rate?
11. 11. If it does, how?
12. 12. Does interest rate affect exchange rate?
13. 13. If it does, how?
14. 14. How can we arrive at a more proper and actual exchange rate?</li></li></ul><li>Theories of exchange rate determination<br />
15. 15. Purchasing Power Parity<br />The PPP theory focuses on the inflation – exchange rate relationships.<br />If the law of one price holds for all goods and services, we can obtain the theory of PPP.<br />LAW OF ONE PRICE<br />
16. 16. Law Of One Price<br />Law of one price states “ In an efficient all identical goods must have only one price”<br />Identical goods should sell at identical prices in different markets<br />If not, arbitrage opportunities exist<br />Assumes that there will be no shipping costs, tariffs, taxes….etc.<br />Relates to a particular commodity, security, asset etc..<br />
17. 17. Example<br />Price of wheat in France (per bushel): P€<br />Price of wheat in U.S. (per bushel): P\$<br />S€/\$ = spot exchange rate<br /><ul><li>Example: </li></ul>Price of wheat in France per bushel (p€) = 3.45 € <br />Price of wheat in U.S. per bushel (p\$) = \$4.15<br />S€/\$ = 0.8313 (s\$/€ = 1.2028)<br />Dollar equivalent price<br />of wheat in France = s\$/€ x p€<br /> = 1.2017 \$/€ x 3.45 € = \$4.1676<br />P€ = S€/\$  P\$<br />
18. 18. Historical back drop<br />A Swedish economist Gustav Cassel introduced the PPP theory in 1920s<br />Countries like Germany, Hungary and Soviet Union experienced hyperinflation in those years due to World War I<br />The purchasing power of these currencies declined sharply<br />The currencies depreciated sharply against more stable currencies like the US dollar<br />
19. 19. Absolute PPP<br />Law of one price extended to<br />a basket of goods <br />If the price of the <br /> basket in the U.S.<br /> rises relative to the<br /> price in Euros, the US<br /> dollar depreciates<br />
20. 20. Have a look<br />If the price of the basket in the U.S. rises relative<br />to the price in Euros, over a period of three days<br />May 21 : s€/\$ = P€ / PUS<br /> = 1235.75 € / \$1482.07 = 0.8338 €/\$<br />May 24: s€/\$ = 1235.75 € / \$1485.01 = 0.83215 €/\$<br />Has the US dollar appreciated or <br />depreciated?<br />
21. 21. Mathematically , Absolute PPP postulates that<br />Pais the general price level in country A<br />Pbis the general price level in country B<br />sa/bis the exchange rate between currency of country A and currency of country B<br />sa/b = Pa / Pb<br />
22. 22. Statement<br />The absolute PPP postulates that the equilibrium<br /> exchange rate between currencies of two countries<br /> is equal to the ratio of the price levels in the two<br /> nations.<br />Thus, prices of similar products of two<br /> countries should be equal when measured<br /> in a common currency as per the absolute<br /> version of PPP theory<br />
23. 23. Deviations from absolute PPP<br />
24. 24. Big Mac and PPP<br />