TOPIC4: THE ECONOMICS OF INTENATIONAL FINANCE
4.1: PURCHASING POWER PARITY (PPP)
If home inflation is lower than that of the foreign country, the home currency
should be strong in value.
The PPP is the key theory that explains the relationship between currencies; in
essence it claims that a
change in relative inflation must result in a change in exchange rates in order to
keep prices of goods in two countries fairly similar.
The PPP is useful in explaining the relationship between exchange rates, but is
not perfect. We need to
make assumption about equilibrium exchange rates at some starting point and
recognize that currencies
are rarely related accurately in two-country world. When several currencies are
involved, it is difficult to use prices to determine an equilibrium rate. Exchange
rates are essentially functioning of traded goods, whereas inflation relates to all
goods whether traded or not.
The implication is that the exchange will be determined in some way by the
relationship between prices.
This arises from the law of one price. The law of one-price states, that “in a free
market with no barriers
to trade no transport or transaction cost, the competitive process will ensure
that there will only be one
price for any given good”
In its exchange rate, it follows that if inflation rates can be predicted, so can
movements in exchange
rates.
In practice, the purchasing power parity model has shown some weakness and is
a poor predictor of
short term changes in exchange rates.
It ignores the effects of capital movement on the exchange rate.
Trade and therefore exchange rates will only reflect the prices of goods
which enter into international trade and not the general price level since
this include no-tradable
Government may manage exchange rates. E.g. by interest rate policy
It is likely that the purchasing power parity model may be more useful for
predicting long run changes in exchange rates since these are more likely to be
determined by the underlying competitiveness of economies as measured by the
model.
If price differences occurred they would be removed by arbitrage, entrepreneurs
would buy in the market and resell in the high market. This would eradicate the
price difference.
If this law is applied to international transactions, it suggests that exchange
rates will always adjust to
, ensure that only one price exists between countries where there is relatively free
trade.
Thus if a typical set cost £500 in the UK, free trade would produce an exchange
rate of 1 £to $2.
How does this result come about? Let us suppose that the rate of exchange was
$1.5 to £1, the sequence
of events would be: -
US purchaser could buy UK goods more cheaply
There would be flow of UK exports to US this would represent demand for
sterling
The sterling exchange rate would rise
When the exchange rate reached $2 to 1£, there would be no extra US
demand for UK exports since prices would have been equalized.
Purchasing power parity would have been established.
The clear prediction of the purchasing power parity model of exchange rate
determination is that, if a
country experiences a faster rate of inflation than its trading partners, it will
experience depreciation.
Forms of Purchasing Power Parity
There are two forms of PPP
(i) Absolute form of PPP
(ii) Relative form
They are discussed as follows: -
(i) The Absolute Form
The absolute form also is called the “law of one price” it suggests that prices of
similar products of two different countries should be equal when measured in a
common currency.
If a discrepancy in [prices as measured by a common currency exists, the
demand should shift so that
these prices should converge.
Illustration
Let PURT = the price of commodity in Tanzania
PK = the price of similar commodity in Kenya
Expected exchange rate Tshs against Kshs is expressed as E (Tshs/Kshs)
The law of one price is given as:-
PURT = E (Tshs/Kshs) x PK. ………………………………(1)
Rearranging the equation above
E (Tshs/Kshs) = PURT/ PK …………………(2)
That is the ratio of relative inflation rates.
If inflation falls in Kenya the right hand side of equation (2) above will become
smaller, thus the exchange rate of Kenya shillings against Tanzania shillings will
fall by a proportional amount (lower
inflation increases value of the Kshs in terms of the exchange rate).
The theory can nevertheless be used to explain the changes in the international
levels of prices and for determining the changes in the exchange rate. For
4.1: PURCHASING POWER PARITY (PPP)
If home inflation is lower than that of the foreign country, the home currency
should be strong in value.
The PPP is the key theory that explains the relationship between currencies; in
essence it claims that a
change in relative inflation must result in a change in exchange rates in order to
keep prices of goods in two countries fairly similar.
The PPP is useful in explaining the relationship between exchange rates, but is
not perfect. We need to
make assumption about equilibrium exchange rates at some starting point and
recognize that currencies
are rarely related accurately in two-country world. When several currencies are
involved, it is difficult to use prices to determine an equilibrium rate. Exchange
rates are essentially functioning of traded goods, whereas inflation relates to all
goods whether traded or not.
The implication is that the exchange will be determined in some way by the
relationship between prices.
This arises from the law of one price. The law of one-price states, that “in a free
market with no barriers
to trade no transport or transaction cost, the competitive process will ensure
that there will only be one
price for any given good”
In its exchange rate, it follows that if inflation rates can be predicted, so can
movements in exchange
rates.
In practice, the purchasing power parity model has shown some weakness and is
a poor predictor of
short term changes in exchange rates.
It ignores the effects of capital movement on the exchange rate.
Trade and therefore exchange rates will only reflect the prices of goods
which enter into international trade and not the general price level since
this include no-tradable
Government may manage exchange rates. E.g. by interest rate policy
It is likely that the purchasing power parity model may be more useful for
predicting long run changes in exchange rates since these are more likely to be
determined by the underlying competitiveness of economies as measured by the
model.
If price differences occurred they would be removed by arbitrage, entrepreneurs
would buy in the market and resell in the high market. This would eradicate the
price difference.
If this law is applied to international transactions, it suggests that exchange
rates will always adjust to
, ensure that only one price exists between countries where there is relatively free
trade.
Thus if a typical set cost £500 in the UK, free trade would produce an exchange
rate of 1 £to $2.
How does this result come about? Let us suppose that the rate of exchange was
$1.5 to £1, the sequence
of events would be: -
US purchaser could buy UK goods more cheaply
There would be flow of UK exports to US this would represent demand for
sterling
The sterling exchange rate would rise
When the exchange rate reached $2 to 1£, there would be no extra US
demand for UK exports since prices would have been equalized.
Purchasing power parity would have been established.
The clear prediction of the purchasing power parity model of exchange rate
determination is that, if a
country experiences a faster rate of inflation than its trading partners, it will
experience depreciation.
Forms of Purchasing Power Parity
There are two forms of PPP
(i) Absolute form of PPP
(ii) Relative form
They are discussed as follows: -
(i) The Absolute Form
The absolute form also is called the “law of one price” it suggests that prices of
similar products of two different countries should be equal when measured in a
common currency.
If a discrepancy in [prices as measured by a common currency exists, the
demand should shift so that
these prices should converge.
Illustration
Let PURT = the price of commodity in Tanzania
PK = the price of similar commodity in Kenya
Expected exchange rate Tshs against Kshs is expressed as E (Tshs/Kshs)
The law of one price is given as:-
PURT = E (Tshs/Kshs) x PK. ………………………………(1)
Rearranging the equation above
E (Tshs/Kshs) = PURT/ PK …………………(2)
That is the ratio of relative inflation rates.
If inflation falls in Kenya the right hand side of equation (2) above will become
smaller, thus the exchange rate of Kenya shillings against Tanzania shillings will
fall by a proportional amount (lower
inflation increases value of the Kshs in terms of the exchange rate).
The theory can nevertheless be used to explain the changes in the international
levels of prices and for determining the changes in the exchange rate. For
