The document discusses the concept of purchasing power parity (PPP). It defines PPP as the exchange rate between two currencies that would equalize the purchasing power of the currencies in their respective countries. The document notes that under PPP, a given amount of one currency should have the same purchasing power whether used directly to purchase goods in that country or converted to the other currency at the PPP rate. It then asks several questions about how inflation, interest rates, and other factors may impact exchange rates. The rest of the document provides explanations of absolute and relative PPP, how PPP is used to make cross-country comparisons, and some limitations of the PPP theory.

1. PRESENTED BY VEERESH AND SANTHOSH.M
Purchasing Power
Parity

2. INTRODUCTION
The concept of purchasing power parity allows one to estimate what
the exchange rate between two currencies would have to be in order for
the exchange to be on par with the purchasing power of the two countries'
currencies. Using that PPP rate for hypothetical currency conversions, a
given amount of one currency thus has the same purchasing power
whether used directly to purchase a market basket of goods or used to
convert at the PPP rate to the other currency and then purchase the market
basket using that currency. Observed deviations of the exchange rate from
purchasing power parity are measured by deviations of the real exchange
rate from its PPP value of 1.

3. 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?

4. Theories of exchange rate
determination
Purchasing Power
Parity
International
Fisher Effect
The Interest
Rate Parity

5. Purchasing Power Parity
The 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

6. Law Of One Price
Law of one price states “ In an efficient all identical
goods must have only one price”
Identical goods should sell at identical prices in
different markets
If not, arbitrage opportunities exist
Assumes that there will be no shipping costs, tariffs,
taxes….etc.
Relates to a particular commodity, security, asset
etc..

7. Cont..
 Example
Price of wheat in France (per bushel): P€
Price 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$) = $4.15
S€/$ = 0.8313 (s$/€ = 1.2028)
Dollar equivalent price
of wheat in France = s$/€ x p€
= 1.2028 $/€ x 3.45 € = $4.1496
P€ = S€/$  P$

8. Historical back drop
A 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

9. TYPES OF PPP
Absolute PPP
Relative PPP
RELATIVE PPP : Relative purchasing power parity is an economic
theory which predicts a relationship between the inflation rates of two
countries over a specified period and the movement in the exchange
rate between their two currencies over the same period. It is a dynamic
version of the absolute PPP theory

10. Absolute PPP
Law 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

11. ADVANTAGES OF PPP THEORY
Purchasing power parity is important for developing
reasonably accurate economic statistics to compare the
market conditions of different countries. For example,
purchasing power parity is often used to equalize
calculations of gross domestic product. Because
purchasing power can vary from country to country,
the statistic for GDP based on purchasing power parity
is often different than nominal GDP -- GDP as
described by currency exchange alone.

12. Have a look
If the price of the basket in the U.S. rises relative
to 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?

13. Mathematically , Absolute PPP postulates that
Pa is the general price level in country A
Pb is the general price level in country B
sa/b is the exchange rate between currency of country A and
currency of country B
sa/b = Pa / Pb

14. Statement
The 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 theory

15. Deviations from absolute
PPP
Simplistic
model
Transportation
costs Tariffs and
taxes
Consumption
patterns differ
Non-traded
goods & services
Imperfect
Markets
Sticky prices
Markets don’t
work well
Statistical
difficulties
Construction of
price indexes
Different goods
Price index
includes tradable
and non tradable
goods

16. LIMITATIONS OF PPP THEORY
The theory assumes that changes in price levels could bring
about changes in exchange rates not vice versa, that is,
changes in exchange rates cannot affect domestic price levels
of the countries concerned.
The calculated new rate would represent the equilibrium rate
at purchasing power parity only if economic conditions have
remained unchanged.
According to the theory, to calculate the new equilibrium
rate one must know the base rate i.e., the old equilibrium rate.
But it is difficult to ascertain the particular rate which actually
prevailed between the currencies as the equilibrium rate.
The exchange rate is directly related to the purchasing power
of currencies of two countries

17. CONCLUSION
PPP exchange rates help to avoid misleading international comparisons
that can arise with the use of market exchange rates. For example,
suppose that two countries produce the same physical amounts of goods
as each other in each of two different years. Since market exchange rates
fluctuate substantially, when the GDP of one country measured in its own
currency is converted to the other country's currency using market
exchange rates, one country might be inferred to have higher real
GDP than the other country in one year but lower in the other; both of
these inferences would fail to reflect the reality of their relative levels of
production. But if one country's GDP is converted into the other country's
currency using PPP exchange rates instead of observed market exchange
rates, the false inference will not occur.

18. Thank you