Lecture 7.
International Parity
Relationships (2)
Purchasing Power Parity 1
• When the law of one price is applied internationally to a standard
consumption basket, we obtain the theory of purchasing power parity
(PPP).
• The exchange rate between currencies of two countries should be equal
to the ratio of the countries’ price levels of a commodity basket.
• Let 𝑃$ be the dollar price of the standard consumption basket in the U.S.
and 𝑃£ be the pound price of the same basket in the U.K.
• Absolute version of PPP states the exchange rate between the dollar
and pound should be:
𝑆 = 𝑃$ /𝑃£
Purchasing Power Parity
• When the PPP relationship is presented in the “rate of change” form,
instead of price level as in the absolute version of PPP, we obtain the
relative version of PPP:
ép - p ù
e=ê $
ú » p -p£
ë 1+ p û
$ £
where:
e is the rate of change in the exchange rate.
𝜋$ and 𝜋£ are the inflation rates in the United States and U.K., respectively.
Purchasing Power Parity
• Derivation:
Let 𝑃$# = (1 + 𝜋$ )𝑃$ , 𝑃£# = (1 + 𝜋£ )𝑃£ , 𝑆 # = 1 + 𝑒 𝑆
𝑆 # = 𝑃$# /𝑃£#
1 + 𝑒 𝑆 = (1 + 𝜋$ )𝑃$ /(1 + 𝜋£ )𝑃£
𝑃$ = 𝑆𝑃£
1 + 𝑒 𝑆 = (1 + 𝜋$ )𝑆𝑃£ /(1 + 𝜋£ )𝑃£
1 + 𝑒 = (1 + 𝜋$ )/(1 + 𝜋£ )
1 + 𝜋$ 𝜋$ − 𝜋£
𝑒= −1 or 𝑒=
1 + 𝜋£ 1 + 𝜋£
PPP Deviations and the Real Exchange Rate
• If there are deviations from PPP, changes in nominal exchange rates
cause changes in the real exchange rates, affecting the international
competitive positions of countries
• Real exchange rate, q, is found by:
1 + 𝜋$
𝑞=
(1 + 𝑒)(1 + 𝜋£ )
• If PPP holds, the real exchange rate will be unity (that is, q = 1).
• When PPP is violated, the real exchange rate will deviate from unity.
PPP Deviations and the Real Exchange Rate
1 + 𝜋$ (1 + 𝜋$ )
𝑞= < (1 + 𝑒)
(1 + 𝑒)(1 + 𝜋£) (1 + 𝜋£ )
• 𝑞 = 1 : Competitiveness of the domestic country unaltered.
• 𝑞 < 1 : Competitiveness of the domestic country improves.
• 𝑞 > 1 : Competitiveness of the domestic country deteriorates.
• Example:
• The annual inflation rate is 5 percent in the United States and 3.5 percent in
the U.K., and the pound appreciated against the dollar by 4.5 percent. Then
the real exchange rate is 0.97.
• The dollar depreciated by more than is warranted by PPP
• Strengthening the competitiveness of U.S. industries in the world market
Real Effective Exchange Rates for Selected Currencies (index, 2010 = 100)
Big Mac Index
• Introduced by The Economist magazine in 1986.
• Uses the price of a Big Mac hamburger sold by McDonald's as the
benchmark item to compare the purchasing power between different
countries' currencies.
• A Big Mac is a standardized product that includes similar ingredients
and is available in numerous countries around the globe, making it a
useful tool for this kind of comparison.
• Calculates the PPP between currencies by comparing the price of a
Big Mac in two countries, converting the price of the Big Mac in one
country into the currency of the other country using current exchange
rates, and then assessing the difference.
The Big Mac Index in 2021
• Price in dollars: Local currency
price divided by the actual dollar
exchange rate.
• Purchasing power parity: Local
currency price divided by price
in the United States.
• https://www.economist.com/big-
mac-index
• c.f., Starbucks Index
https://www.economist.com/fina
nce-and-
economics/2004/01/15/burgers-
or-beans
Note: All prices include tax.
Sources: The Economist, July 2021.
Evidence on PPP
• PPP has been the subject of a series of tests, yielding generally
negative results, especially over short horizons.
• PPP doesn’t hold precisely for a variety of reasons.
• Nontradable or nonstandardized goods.
• Shipping costs.
• Tariffs and quotas.
• PPP–determined exchange rates still provide a valuable benchmark.
Fisher Effects
• An economic theory proposed by economist Irving Fisher that describes
the relationship between inflation and both real and nominal interest
rates.
1 + 𝑖 = (1 + 𝜌)(1 + 𝜋)
where
• 𝑖 : nominal interest rate.
• 𝜌 : real interest rate.
• 𝜋 : expected inflation rate.
Alternatively,
𝑖 =𝜌+𝜋+𝜌×𝜋 ≈𝜌+𝜋
Fisher Effects
• Formally, the Fisher effect can be written for the U.S. as follows:
𝑖$ = 𝜌$ + 𝐸 𝜋$ + 𝜌$ 𝐸 𝜋$ ≈ 𝜌$ + 𝐸 𝜋$
• The Fisher effect holds that an increase (decrease) in the expected
inflation rate in a country will cause a proportionate increase (decrease)
in the interest rate in the country.
• Fisher effect implies that the expected inflation rate is the difference
between the nominal and real interest.
𝐸 𝜋$ = 𝑖$ − 𝜌$ /(1 + 𝜌$ ) ≈ 𝑖$ − 𝜌$
International Fisher Effects (IFE)
• Relative version of PPP:
𝜋$ − 𝜋£
𝑒= ≈ 𝜋$ − 𝜋£
1 + 𝜋£
• Fisher Effects:
𝐸 𝜋$ = (𝑖$ − 𝜌$ )/(1 + 𝜌$ ) ≈ 𝑖$ − 𝜌$
𝐸 𝜋£ = (𝑖£ − 𝜌£)/(1 + 𝜌£) ≈ 𝑖£ − 𝜌£
• By integrating these two relationships,
𝐸 𝑒 ≈ 𝐸 𝜋$ − 𝐸 𝜋£ ≈ (𝑖$ − 𝜌$ ) − (𝑖$ − 𝜌£)
International Fisher Effects (IFE)
• We now assume that 𝜌$ = 𝜌£ because of unrestricted capital flows
across countries.
𝐸 𝑒 ≈ 𝐸 𝜋$ − 𝐸 𝜋£ ≈ (𝑖$ − 𝜌$ ) − (𝑖£ − 𝜌£)
𝐸 𝑒 ≈ 𝑖$ − 𝑖£
• International Fisher Effects (IFE): The expected change in the spot
exchange rate between two countries is the difference in the interest
rates between the two countries.
International Fisher Effects (IFE)
• International Fisher Effects (IFE) suggests that the nominal interest
rate differential reflects the expected change in exchange rate.
• When the international Fisher effect is combined with IRP, we obtain
the forward expectations parity (FEP):
𝐹−𝑆
= 𝐸(𝑒)
𝑆
• The forward expectations parity (FEP) states that any forward
premium or discount is equal to the expected change in the exchange
rate.
International Parity Relationships among Exchange
Rates, Interest Rates, and Inflation Rates
