PURCHASING POWER

PARITY THEORY

CH 6
• A model of exchange rate determination
• Long run
• Some phenomenon in a flexible exchange rate, it can not explain.
• PPP and law of one price
• PPP is based on the theory of law of one price
• Law of one price
• In the presence of competitive market, absence of transportation
cost and other barrier to trade, identical products sold in difference
locations, will have the same price
• To sum up: Arbitrage forces will lead to equalization of goods prices
internationally, once the price measured in the same currency

PURCHASING POWER
PARITY
PURCHASING POWER
PARITY
Comes in two forms:
1. Absolute PPP
2. Relative PPP
1) Absolute PPP holds if one take a bundle of goods in one country and
compares the price of that bundle with an identical bundle of goods sold
in a foreign country converted by the exchange rate into a common
currency of measurement
p
S=
p*
where S is exchange rate measured in local/1foreign currency
P is price of bundle of goods in domestic currency
P* is price of the same bundle of goods in foreign currency

Based on Absolute PPP, a rise in home country

price leads to depreciation of the local currency
 Absolute PPP

Example

In US: $ 200
In UK: £100 £160
If PPP holds, then the exchange rate between £ and US$ is £100/$200 = £0.5/1US$

If PPP holds, what happen if price of the same product in domestic market increased?

Exchange Rate will increase by the amount of increase of price : £160/$200 =£0.8/1US%
 Absolute PPP

Example

In US: $ 200
In UK: £100

If PPP holds, then the exchange rate between £ and US$ is £100/$200 = £0.5/1US$

If PPP holds, what happen if price of the same product in domestic market increased?

Exchange Rate will increase by the amount of increase of price

• Maybe!......Maybe not!

Does Absolute PPP holds

in reality?
Some economist suggests that Absolute PPP does not hold in
reality but the weak version of PPP, which is relative PPP might
does hold….the relative PPP

2. Relative PPP
%

%DS = %Dp - %Dp *

If PPP holds, the percentage change in exchange rate

( the rate of depreciation or appreciation) will be equal to differences in
% change in price in the two countries (differences in inflation rate)
Generalized Version of PPP
This model assumes PPP holds for tradable goods

Pt = SPt *

Pt = price of tradable goods in domestic market in local currency

Pt* = price of tradable goods in foreign market in foreign currency

In a country, goods comprise of tradable and non tradable, PPP

So, PPP considering tradable and non tradable goods can be expressed as follow
Reality Check on PPP
• Statistical problem to measure inflation
• No identical basket
PPP
• Transport cost and trade impediments is hard to
• Imperfect competition find !
• Differences between capital and goods
market
• Productivity differentials

Measurement problems
in testing for PPP
BIG MAC index is another way to check price similarity across countries

PPP HOLDS!

BIG MAC INDEX

http://www.economist.com/content/big-mac-index
• Harga Big Mac di AS (PAS) = US$4.2
• Harga Big Mac di Norwegia (PN): 41 kroner
• Berapa Nilai tukar pada tingkat PPP:
• PN/PAS : 9.7 kroner/US$

• Bila nilai tukar aktual (Kroner/US$) = 6.04 kroner/ 1 US$

• Pertanyaan: apakah nilai tukar aktual lebih tinggi
(overvalue) dari pada PPP?
• YA!

Harga pada Januari tahun

2012
• Harga Big Mac di AS (PAS) = US$4.2 $5.04 July (2016)
• Harga Big Mac di Norwegia (PN): 41 kroner 46.8 kroner
• Berapa Nilai tukar pada tingkat PPP:
• PN/PAS : 9.7 kroner/US$ 46.8/5.04 = 9.29

• Bila Nnilai tukar aktual (Kroner/US$) = 6.04 8.8.48

kroner/US$
• Pertanyaan: apakah nilai tukar aktual lebih tinggi
(overvalue) dari pada PPP?
• YA!

Harga pada Juli 2016

• Can show whether a currency is overvalue or undervalue
relative to other currency

• Open this link http://www.economist.com/content/big-

mac-index

BIG MAC INDEX

CONVENTIONAL GDP VS GDP USING PPP

• Open this link

http://data.worldbank.org/indicator/NY.GDP.PCAP.PP.CD
Enjoy your Big Mac and
International finance