Chapter Eight: The Purchasing Power Parity (PPP) in International Finance and Investment Introduction: In the field of international finance and investment, the concept of Purchasing Power Parity (PPP) holds significant importance. The PPP theory aims to measure and compare the relative value of currencies across different countries by taking into account the differences in price levels and inflation rates. This chapter delves into the intricacies of PPP, its applications, limitations, and the implications it holds for international trade and investment. 1. Understanding Purchasing Power Parity (PPP): 1.1 Definition and Basic Principles: The Purchasing Power Parity (PPP) is a theory that suggests that the exchange rates between two currencies should equalize the purchasing power of those currencies. In simpler terms, it posits that a basket of goods should have the same cost in different countries when expressed in a common currency. PPP is based on the idea that in the long run, exchange rates will adjust to ensure that goods have the same price across countries. 1.2 Absolute and Relative PPP: PPP can be divided into two categories: absolute and relative. Absolute PPP states that the exchange rate between two currencies should be equal to the ratio of the price levels of a basket of goods in each country. On the other hand, relative PPP compares the changes in the price levels and inflation rates between two countries over time, with the aim of predicting future exchange rate movements. 2. Applications of Purchasing Power Parity: 2.1 Exchange Rate Determination: One of the primary applications of PPP is in the determination of exchange rates. PPP suggests that if the price levels in Country A rise faster than in Country B, the currency of Country A should depreciate against the currency of Country B. This principle helps economists and investors understand and predict exchange rate movements, aiding in decision-making processes for international trade and investment. 2.2 International Price Comparisons: PPP serves as a valuable tool for comparing the relative prices of goods and services between different countries. By converting local currencies into a common currency using PPP exchange rates, economists and policymakers can make more accurate cross-country comparisons of living standards, inflation rates, and overall economic performance. This information is crucial for assessing global competitiveness and making informed policy decisions. 2.3 PPP-Based Valuation of Currencies: PPP can also be used to estimate the fair value of a currency relative to another currency. By comparing the actual exchange rate to the PPP exchange rate, analysts can determine whether a currency is overvalued or undervalued. This valuation method is particularly helpful for investors and multinational corporations when deciding to enter foreign markets or hedge against currency risks.

1. CHAPTER 8
Purchasing Power
Parity and Real
Exchange Rates

2. Purchasing power refers to the
amount of goods and services that
you can buy with a unit of
currency.
Example
Suppose that you have $10. In 1950,
that $10 could buy you a lot more
groceries, gasoline, or movie tickets than
it can today due because the purchasing
power of the dollar has decreased over
time due to inflation.
4-2
Purchasing Power Parity and Real
Exchange Rates

3. Purchasing Power Parity (PPP) . PPP links exchange
rates to the prices of goods in different countries,
PPP provides a baseline forecast of future exchange
rates that is usually considered whenever it is
necessary to forecast future cash flows in different
currencies, especially when inflation rates differ across
these countries.
4-3
Purchasing Power Parity and Real
Exchange Rates

4. External purchasing power (EPP) refers to the ability
of a currency to purchase goods and services from
other countries.
In other words, it's how much foreign currency you can get for one unit
of your domestic currency.
This is influenced by factors like the exchange rate, inflation rates in
different countries, and the relative demand for different currencies.
Internal purchasing power (IPP) refers to the ability of
a currency to purchase goods and services within its
own country.
4-4
Purchasing Power Parity and Real
Exchange Rates

5. © 2018 Cambridge University Press 4-5
Calculating the Cumulative Rate of Inflation
How do we determine the total amount of inflation between 1985 and
2010 for the United States, and how can we calculate the average
annual rate of inflation during that same period?
First, because 1985 is the base year, we know that 1985 = 100. Because
the U.S. price index in 2010 was 199.3, we know that the average dollar
prices of goods and services in 2010 were 99.3% higher than were the
prices in 1985.
Over the 25 years, prices increased at a compound annual rate of
inflation of 2.79% because

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Calculating the Purchasing Power
of $1,000,000
Suppose the price level in the United States is $15,000 for the
average consumption bundle.
• What is the purchasing power of $1,000,000?
The purchasing power of 1 dollar is (1/15,000), so the
purchasing power of $1,000,000 is

7. © 2018 Cambridge University Press 4-7
Internal Purchasing Power
Calculating the Purchasing Power of $1,000,000
Suppose the price level in the United States is $15,000 for the
average consumption bundle. What is the purchasing power of
$1,000,000?
The purchasing power of 1 dollar is (1/15,000), so the
purchasing power of $1,000,000 is

8. © 2018 Cambridge University Press 4-8
External Purchasing Power
The units of the external purchasing power of a dollar are the
amount of goods and services outside the United States that
can be purchased with a dollar,

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A Goods Market Arbitrage
• Suppose that the U.S. price level is $15,000/consumption bundle and
that the U.K. price level is £10,000/consumption bundle.
• Let the exchange rate be $1.40/£. Rather than compute the purchasing
power of 1 dollar, consider the internal and external purchasing powers
of $1 million.
• As we saw earlier, the internal purchasing power of $1 million in the
United States is

10. © 2018 Cambridge University Press 4-10
A Goods Market Arbitrage
However, if the external purchasing power of the dollar in the United
Kingdom is higher than the internal purchasing power of the dollar in the
United States, we can profit by buying goods in the United Kingdom and
shipping them to the United States for resale.
If we buy goods in the United Kingdom, we can purchase 71.43
consumption bundles with our $1 million. If we sell the 71.43 consumption
bundles in the United States at $15,000/consumption bundle, we will
receive

11. © 2018 Cambridge University Press 4-11
The Warranted Change
in the Exchange Rate
Suppose, as in Example 8.4, that the price level in the United States is
initially $15,000/U.S. consumption bundle, the price level in the United
Kingdom is initially £10,000/U.K. consumption bundle, and the exchange
rate is $1.40/£. We determined that absolute PPP is violated. The pound is
undervalued on foreign exchange markets because the implied PPP
exchange rate of
is not equal to the actual exchange rate. The pound would have to
strengthen relative to the dollar by 7.14% to correct its undervaluation
because

12. © 2018 Cambridge University Press 4-12
The Warranted Change
in the Exchange Rate
Now, suppose that during the following year, the rate of U.S.
inflation is 3%, and the rate of U.K. inflation is 10%. From the
definition of inflation , we know that the new price level in the
United States is 3% higher: