purchasing power parity – how it impacts the market exchange rate
TRANSCRIPT
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Purchasing Power Parity
How it impacts the Market
Exchange rate
Presented By Group I2
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PURCHASING POWER PARITY AN
INTRODUCTION
PPP Exchange rate between two countries at
which the their currencies have the same
purchasing power
At PPP exchange rate, a basket of goods will costthe same in both the countries
PPP measurement is a complex task since it is
difficult to decide which items to include in the
basket of goods
Different countries consume different basket of
goods
Example of a PPP measure Big Mac Index
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BIG MAC INDEX
Its an informal but very popular way of measuringPPP between two countries. It is published by TheEconomist
Its based on the price of Big Mac, a hamburger soldat most McDonald's restaurants
Here the "basket of goods" taken is the single BigMac burger and its price is compared across thedifferent countries to arrive at the PPP exchange rate
The two prominent reasons why the Big Mac ischosen for measuring PPP is that
- It is available in almost all countries and theingredients
of Big Mac remain same across many countries
- It is a simple and easy way of measuring and
understanding the PPP
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BIG MAC INDEX
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PPPAS A THEORY OF EXCHANGE RATE
DETERMINATION
PPP theory explains changes in countrys marketexchange rate
According to it, if the cost of a basket of goods isdifferent in two countries, then profit-seekingindividuals will buy the goods in the low costcountry and resell them in the high cost country
This behaviour of importers and exporters willaffect the demand and supply of currencies in theForex market
Hence it will impact the spot exchange rate
Example of US and Mexican markets UScurrency is dollar and Mexican currency is Pesos
PPP exchange rate, EPPPP/$ = CBP /CB$
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SCENARIOS
Scenario I Market exchange rate is greater than thePPP exchange rate
EP/$ > CBP /CB$EP/$ CB$ > CBP
This implies that on an average US goods are moreexpensive than Mexican goods
This will cause US importers to purchase more of theless expensive goods in Mexico
To purchase goods from Mexico, they will have toraise the supply of dollars in the Forex in exchangefor pesos
Thus, the supply curve of dollars on the Forex Marketwill shift to the right
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CONTD Also, Mexican importers will buy less
of the more expensive US goods
This will lead to a reduction indemand for dollars in exchange forpesos on the Forex market
Hence the demand curve for dollarson the Forex will shift to the left
Due to the demand decrease and thesupply increase, the exchange rate,Ep/$ will fall
This means that the dollar willdepreciate and the peso will
appreciate This will continue till the exchange
rate equals the PPP exchange rate ,that is the cost of the basketsbecome equal in both the countries
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CONTD
Scenario II Market exchange rate islower than the PPP exchange rate
EP/$ < CBP /CB$ EP/$ CB$ < CBP This implies that on an average US
goods are cheaper than Mexican
goods This will cause Mexican importers to
buy more of the cheaper goods in US
To buy more US goods, Mexicanimporters will have to increase the
demand for US dollars in exchangefor pesos on the foreign exchangemarket.
This will cause a rightward shift inthe US dollar demand on the ForexMarket
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CONTD
Also, US importers will buy less of the moreexpensive Mexican goods
This will reduce the supply of dollars in exchangefor pesos on the Forex
This will cause a leftward shift in the US dollarsupply curve in the Forex market.
Both the shift in demand and supply will causethe exchange rate, Ep/$ to rise
This means that the dollar will appreciate andthe peso will depreciate
This will continue till the exchange rate equalsthe PPP exchange rate , that is the cost ofbaskets becomes equal in both countries
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PROBLEMS AND EXTENSIONS OF PPP
PPP condition is rarely satisfied in the country
Market exchange rate is rarely the same as the
PPP exchange rate
Reasons- Transportation costs and trade restrictions
- Non tradable inputs drive the prices of the
baskets different
- Individuals do not have perfect informationabout the prices of goods in other markets
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PPP IN THE LONG RUN
It is rare for the PPP relationship to hold true
between any two countries, at any particular
point in time
Economists think of PPP as a 'Long-Run" theoryof exchange rate determination rather than a
short run theory
Rationale for Long run theory - importers and
exporters cannot respond quickly to price
differences in the baskets between countries
When there is a delayed response, PPP no longer
holds at a particular point in time
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CONTD
But eventually traders will adjust to the price
differences by buying in low priced markets and
selling high priced markets
This will cause an eventual adjustment of thespot exchange rate towards the PPP rate
As adjustment occurs, it is possible that the PPP
exchange rate also continues to change
In that case, the spot exchange rate is adjustingtowards a constantly changing PPP
Hence, the Exchange rate may never be able to
catch up with the PPP rate
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LONG RUN PPP THEORY
PPP rate hardly ever
equals the marketexchange rate
Market exchange rate
follows the same trend
as the PPP exchange
rate
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WHAT CAUSES CHANGE IN PPP EXCHANGE
RATE?
PPP exchange rate depends on the price of the
basket of goods in the two countries
Price of the basket of goods in turn depends on
the inflation rates in the two countries If the inflation rates are same in both countries,
the ratio of the cost of the baskets remains the
same
Hence PPP exchange rate remains the same
Differential inflation rates will drive the cost of
the basket of goods different. Hence PPP rate will
change
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OVERVALUATION AND UNDERVALUATION
OF ACURRENCY
Overvaluation
If the US dollar is overvalued with respect to the
Mexican peso, then the spot exchange rate exceeds
the PPP exchange rate
- EP/$ > EPPP
P/$
- EP/$ > CBP /CB$
- EP/$ CB$ > CBP
Cost of the basket in US converted to pesos at the
current spot exchange rate is greater than cost of the
basket in Mexico also evaluated in pesos
Goods and services cost more on average in the US
than in Mexico
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Undervaluation If the US dollar is undervalued with respect to
the Mexican peso, then the spot exchange ratewill be lower than the PPP exchange rate
- EP/$ < EPPP
P/$
- EP/$ < CBP /CB$- EP/$ CB$ < CBP Cost of the basket in US converted to pesos at
the current spot exchange rate is less than cost ofthe basket in Mexico also evaluated in pesos
Goods and services cost less on average in the USthan in Mexico
OVERVALUATION AND UNDERVALUATION
OF ACURRENCY
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APPLICATIONS OF PPP
Cross country comparisons Income, GDP, per
capita GDP,etc
Helps in converting the figures to same units
that can be compared Spot exchange rate does not paint the true
picture
PPP gives a measure of the true welfare of the
people
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Thank You