purchasing power parity

Eco 328purchasing power parity

The Law of One Price

What if Reebok hockey sticks were selling for $150 in New York and $350 in Montreal?

Arbitrage occurs in the international goods markets just as in the international financial markets.

Therefore, there is an equalizing force acting on prices of goods in different countries expressed in a common currency.

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The law of one price (LOOP) states that in the absence of trade frictions and under free competition and price flexibility, identical goods sold in different locations must sell for the same price when expressed in a common currency.

We can write the relative price as follows, for the case of any good g sold in two locations:

The Law of One Price

$in good of

price U.S.

$in good ofpriceEuropean

/$

U.S. versusEuropein good of price Relative

/ /)(

g

g

US

g

g

EUR

g

g

EURUS PPEq

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We can rearrange the equation for price equality

The Law of One Price

to suggest that the exchange rate ought to equal the ratio of the goods prices expressed in the two currencies:

g

US

g

EUR PPE /$

prices goodsof Ratio

rateExchange

/$ /g

EUR

g

US PPE

Purchasing Power Parity

Suppose now one put together a basket of goods, including not just hockey sticks, but milk, eggs and gasoline too.

What would happen if the same two baskets were selling for different amounts of $$ in the US and Canada?

Same thing goods arbitrage until the same basket of goods sells for the same price in both countries when expressed in a common currency.

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How about this basket? FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals,

snacks)

HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

APPAREL (men's shirts and sweaters, women's dresses, jewelry)

TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

This is the basket for CPI calculation!Therefore, the price of this basket is the price level, by which we can compare prices

and inflation across time and countries.

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The principle of purchasing power parity (PPP) is the macroeconomic counterpart to the microeconomic law of one price (LOOP). To express PPP algebraically, we can compute the relative price of the two baskets of goods in each location:

Purchasing Power Parity

$in expressed

basket ofprice U.S.

$in expressed

basket ofpriceEuropean

/$

U.S.versusEuropein basket of

price Relat ive

/ /)( USEUREURUS PPEq

There is no arbitrage when the basket is the same price in both locations qUS/EUR = 1.

PPP holds when price levels in two countries are equal when expressed in a common currency. This is called absolute PPP.

For example

Suppose the European basket costs 100, and the exchange rate is $1.20 per euro.

For PPP to hold, the U.S. basket would have to cost 1.20 100 = $120.

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The real exchange rate is the relative price of the baskets.

The U.S. real exchange rate qUS/EUR = E$/ PEUR/PUS tells us how many U.S. baskets are needed to purchase one European basket.

The exchange rate for currencies is a nominal concept. The real exchange rate is a real concept.

The real exchange rate has terminology similar to the nominal exchange rate:

If the real exchange rate rises (more Home goods are needed in exchange for Foreign goods), Home has experienced a real depreciation.

If the real exchange rate falls, Home has experienced a real appreciation

The Real Exchange Rate

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Purchasing power parity states that the real exchange rate should equal to 1.

If the real exchange rate qUS/EUR is below 1 then European goods are relatively cheap.

o In this case, the dollar is said to be strong, the euro weak, and we say it is undervalued.

If the real exchange rate qUS/EUR is above 1, then European goods are relatively expensive.

o In this case, the dollar is said to be weak, the euro is strong, and we say the euro is overvalued.

Absolute PPP and the Real Exchange Rate

For example

If a European basket costs E$/PEUR = $550 in dollar terms,

and a U.S. basket costs only PUS = $500,

then qUS/EUR = E$/PEUR /PUS = $550/$500 = 1.10, the euro is strong, and the euro is 10% overvalued against the dollar.

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We can rearrange the no-arbitrage equation for the equality of price levels, to allow us to solve for the exchange rate that would be implied by absolute PPP:

Absolute PPP:

Absolute PPP, Prices, and the Nominal Exchange Rate

USEUR PPE /$

levels price of Ratiorate Exchange

/$ / EURUS PPE

Purchasing power parity implies that the exchange rate at which two currencies trade should be the relative price levels of the two countries.

For example

If a basket of goods costs $460 in the United States and the same basket costs 400 in Europe, the theory of PPP predicts an exchange rate of

$460/400 = $1.15 per euro.

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Absolute PPP, Prices, and the Nominal Exchange Rate

We now have a model that takes as inputs the prices levels in the respective countries and outputs an exchange rate.

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How does our exchange rate model relate to inflation (the rate of change of the price level)?

Lets evaluate both sides of the equation as the variables change.

Relative PPP, Inflation, and Exchange Rate Depreciation

rate exchange nominal theofon depreciati of Rate

,/$

,/$1,/$

,/$

1, /$

t

tt

t

t

E

EE

E

E

levels price of Ratiorate Exchange

/$ / EURUS PPE

For example

If the price level today is 100, and one year from now it is 103.5, then the rate of inflation is

(103.5 100) / 100 =

3.5% (for the year).

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How does our exchange rate model relate to inflation (the rate of change of the price level)?

Relative PPP, Inflation, and Exchange Rate Depreciation

levels price of Ratiorate Exchange

/$ / EURUS PPE

On the right, the rate of change of the ratio of two price levels equals the rate of change of the numerator minus that of the denominator:

EURUS

tEUR

tEURtEUR

tUS

tUStUS

tEUR

tEUR

tUS

tUS

EURUS

EURUS

tEURtUS

P

PP

P

PP

P

P

P

P

PP

PP

,,

Europein inflation of Rate

,

,1,

in U.S.inflation of Rate

,

,1,

,

,

,

,

)/(

)/(

For example

If the price level in the US today is 100, and one year from now it is 103.5, then the US rate of inflation is 3.5%.

If the price level in Europe today is 100, and one year from now it is 105, then the Eurozone rate of inflation is 5%.

The inflation differential between the two is

3.5% - 5% = -1.5%

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Combining the changes on both sides we obtain:

Relative PPP, Inflation, and Exchange Rate Depreciation

This way of expressing PPP is called relative PPP, and it implies that the rate of depreciation of the nominal exchange rate equals the difference between

the inflation rates of two countries.

Unlike absolute PPP, relative PPP predicts a relationship between changes in prices and changes in exchange rates, rather than a relationship between their levels.

aldifferentiInflation

,,

rate exchange nominal theofondepreciati of Rate

,/$

,/$

tEURtUS

t

t

E

E

Relative PPP, Inflation, and Exchange Rate Depreciation

Relative PPP is derived from absolute PPP. Hence, the latter always implies the former: if absolute PPP holds, this implies that relative PPP must hold also.

But the converse need not be true: relative PPP does not necessarily imply absolute PPP (if relative PPP holds, absolute PPP can hold or fail).

For example, imagine that all goods consistently cost 20% more in country A than in country B, so absolute PPP fails; however, it still can be the case that the inflation differential between A and B (say, 5%) is always equal to the rate of depreciation (5%).

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Evidence for PPP in the Long Run

Inflation Differentials and the Exchange Rate, 1975-2005

This scatterplot shows the relationship between the rate of exchange rate depreciation against the U.S. dollar and the inflation differential against the United States over 30 years, for a sample of 82 countries. The correlation between the two variables is strong and bears a close resemblance to the prediction of PPP that all data points would appear on the 45-degree line.

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Evidence for PPP in the Short Run

Exchange Rates and Relative Price Levels

Data for the U.S. and the UK for 1975 to 2010 show that the exchange