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Before we discuss PPP theory let us dig out something from our previous knowledge

Exchange Rate Spot Rate Forward Rate Direct and Indirect Quote Arbitrage Purchasing Power Inflation Perfect or Efficient markets

We will try to find the answers for the following?Can we predict the changes in exchange rate?Does inflation affect exchange rate?If it does, how?Does interest rate affect exchange rate?If it does, how?How can we arrive at a more proper and actual exchange rate?

Theories of exchange rate determinationPurchasing Power ParityThe 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

Law Of One PriceLaw of one price states In an efficient all identical goods must have only one priceIdentical goods should sell at identical prices in different marketsIf not, arbitrage opportunities existAssumes that there will be no shipping costs, tariffs, taxes.etc.Relates to a particular commodity, security, asset etc..ExamplePrice of wheat in France (per bushel): PPrice 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\$) = \$4.15S/\$ = 0.8313 (s\$/ = 1.2028)

Dollar equivalent priceof wheat in France= s\$/ x p= 1.2028 \$/ x 3.45 = \$4.1496

P = S/\$ P\$Historical back dropA 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

Absolute PPPLaw of one price extended to a basket of goods If the price of the basket in the U.S. rises relative to the price in Euros, the US dollar depreciates

Have a lookIf the price of the basket in the U.S. rises relativeto 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?Mathematically , Absolute PPP postulates that

Pa is the general price level in country APb is the general price level in country Bsa/b is the exchange rate between currency of country A and currency of country B

sa/b = Pa / Pb

StatementThe 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 theoryDeviations from absolute PPPBig Mac and PPP

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