Purchasing Power Parity

International Finance
 Presentation Layout
ADNAN ASHRAF PURCHASING POWER PARITY
Interpretation of PPP
Rationality behind PPP

MOIN YAQIN KHAN Using PPP to estimate exchange Rate

Graphical analysis of PPP

ASIF ALI Tests of PPP

ZAINAB QAZI Why PPP doesn’t Holds

ADNAN
ASHRAF Purchasing Power Parity
Interpretation of PPP
Rationality behind PPP
INRs= 240 PKRs= 450
1 INRs 1.94 PKRs

Exchange Rate
 Purchasing Power Parity
• The idea that identical items in different
countries should have the same "real"
prices is very intuitively appealing

• It stands to reason that a consumer should

be able to sell an item in one country and
then buy the same item back in the other
country (and not have any money left over)
 Purchasing Power Parity
• Purchasing-power parity (PPP) is a concept
that states real exchange rate between
domestic and foreign goods is equal to one
• It does not mean that the nominal
exchange rates are constant or equal to
one.
 Purchasing Power Parity
• It is the relation between the exchange rate
and the inflation.
• Theory states that exchange rate must be set
by the inflation rate of the country.
• If the inflation of the country increases up to
5% with respect to some country then the
country must devalue their currency up to 5%
• In case of deflation country must over value
their currency.
A controversial theory
 Interpretation of PPP
Two theories that implies the concept of
PPP

I. Absolute form of PPP

II. Relative form of PPP

 Absolute Form of PPP
• In Absence of international barriers,
consumers will shift their demand to
wherever prices are lowest.
• Equilibrium in the exchange rate between
two currencies will force their purchasing
powers to be equal.
 Relative form of PPP
• Pakistan and Turkey are Trading Partners
• In Turkey inflation raises to 6%
• Pakistan Face an inflation of 5%
• So, according to the relative PPP theory;
Pakistani Rs. Appreciate by the 1% or the
Turkish Lira devalue to 1% to adjust the
price level
• If-ih =6%- 5%= 1% appreciation of PKRs
 Measurement Index for PPP

• Big Mac

• Ipad
 Rational Behind the PPP

• Law of One Price

• Equal the real exchange rate
• Eliminate Arbitrage
MOIN YAQIN
Estimating the Exchange
KHAN Rate Effect
Graphical Analysis of PPP
 Using PPP to estimate the Exchange Rate

• The relatives form of PPP can be used to

estimate how an exchange rate will change
in response to different inflation rates in
two countries
1 Ih
ef  1
1 I f

Simplified PPP relationship

ef ≈ ih-if
Example Focus on White Board…….
 Graphical Analysis of PPP

• PPP Line
The diagonal line connecting all the points
together is the PPP line.
f
 Summary of Purchasing Power Parity
Local currency
Relative high Local Imports will increase should depreciate by
Inflation exports will decrease same degree as
inflation differential

Local currency
Imports will
Relatively low local should appreciate by
decrease exports will
inflation same degree as
increase
inflation differential

Local and foreign No Impact of Local currency’s

inflation rate are inflation on import value is not affected
similar or export volume by inflation
ASIF ALI Testing the
Purchasing Power
Parity
 Testing the Purchasing Power Parity

Simple Test
• Plot actual inflation differentials and
exchange rate % changes for two or more
countries on a graph.
• If the points deviate significantly from the
PPP line over time, then PPP does not
hold.
 Testing the Purchasing Power Parity

Statistical Test
• Apply regression analysis to historical
exchange rates and inflation differentials:
ef = a0 + a1 [ (1+Ih)/(1+If) – 1 ] + m
• Then apply t-tests to the regression
coefficients. (Test for a0 = 0, and a1 = 1.)
• If any coefficient differs significantly from
what was expected, PPP does not hold.
 Testing the Purchasing Power Parity

Results of Statistical test of PPP

• Empirical studies indicate that the
relationship between differentials and
exchange rate is not perfect in the long run.
• However, the use of inflation differentials to
forecast long run movement in exchange
rate is supported.
 Testing the Purchasing Power Parity
Limitations of PPP Tests

 A limitation in the tests is that the choice

of the base period will affect the result.
 If a base period is used when the foreign
currency was relatively weak for reasons
other than high inflation, then most
subsequent period show higher
appreciation of that currency.
ZAINAB QAZI
Why Purchasing Power
Parity Doesn’t Holds
Why Purchasing Power Parity
Doesn’t Hold
As PPP theory is the relationship between the
Exchange rate and Inflation

PPP theory predicts that Exchange rate

movements driven inflation differences
between the countries.
But….
Exchange rate can be effected by numerous
other factors
 Why Purchasing Power Parity
Doesn’t Hold

1. Confounding Effect

2. No Substitute for traded Goods

 CONFOUNDING EFFECT

Confounding means that exchange rate can

be effected by some other surprising or
confusing factors.
 We know that exchange rate can be effected not only due to
inflation but other factors also.

Interest Rate

Income level

Government
CONFOUNDING FACTORS ARE; Controls

Expectations
Lets take an Example
Let suppose that If,
 Inflation in Pakistan rises up to 5% then India.
 PPP theory states that Pakistan exchange rate
must be depreciated by 5%.
 At this stage Pakistan government imposes
restrictions on Indian products and they doesn’t
allow to depreciate exchange rate up to 5%
 Due to this government intervention, exchange
rate couldn’t adjusted so the PPP theory
vanishes.
Numerically we can express this
example as;
 Product A has price in Pakistan= 100
 Price in India = 50
 Exchange rate between the countries
PKRs 2 : INRs 1
 After Inflation price of product “A” rose up to 5%
that will be Rs.105 (100*0.05=105)
 To adjust this inflation Pakistan exchange rate must
be devalued at PKRs.2.10 (2*0.05=2.10)

But forcefully Pakistan govt. doesn’t allow to adjust these

changes due to trade barriers.
Then PPP doesn’t holds.
 No substitute of Traded Goods
When in a country price of foreign goods
rises then consumers will buy the substitute
products.
In case of no substitute available then
consumers have to buy that products at any
cost.
Therefore, the theory doesn’t holds.
No substitute of Traded Goods
Lets take the previous Example
When due to Inflation price of Pakistani
goods rises in Indian Market
They don’t have substitute available in
their market. They buy Pakistani product
at higher prices.
Pakistan couldn’t adjust their exchange
rate according to inflation
This negates the PPP theory.
 Other factors to PPP Theory
• Transportation costs
• Transaction Costs
• Tariffs
• Richer countries have higher price levels
than poor countries
• Some goods are not traded
Internationally
 Controversial
Theory
All these factors suggest that PPP
theory doesn’t holds every time.

So It raises a Question that either to

apply this theory internationally or not.
With practical implications this theory
has some drawbacks.
 Thank You
For
Your Attentions
Questions are Half a
Knowledge

Feel Free to Ask