Purchasing power parity and exchange rates study guide

What is Purchasing Power Parity (PPP)?

PPP is an economic theory that compares different countries' currencies through a basket of goods approach, suggesting that exchange rates should adjust to equalize the price of identical goods in different countries.

How does PPP relate to exchange rates?

PPP suggests that exchange rates should reflect the relative purchasing power of two currencies, established through the price levels of a standard set of goods.

True or False: PPP applies to all goods equally.

False. PPP is most accurate for homogeneous goods, but less so for services and non-tradable goods due to local price variations.

Fill in the blank: According to PPP, if a basket costs $100 in the US and €90 in Europe, the exchange rate should be _____ .

$\displaystyle 1.11 per euro, calculated as$100/€90.

Compare nominal exchange rates and PPP exchange rates.

Nominal exchange rates are the current rates for currency conversion, while PPP exchange rates adjust for price level differences between countries.

What is the Big Mac Index?

A light-hearted measure of PPP that compares the price of a Big Mac burger in various countries to determine if currencies are overvalued or undervalued.

Cause → Effect: If inflation rises in a country, what happens to its currency value via PPP?

The currency typically depreciates, as higher inflation decreases purchasing power compared to other countries.

What does it mean if PPP holds true?

It means that exchange rates accurately reflect the relative purchasing power of currencies based on the price of a common basket of goods.

Explain the Law of One Price.

This law states that in the absence of transportation costs and barriers, identical goods should sell for the same price in different markets when expressed in a common currency.

True or False: PPP can predict short-term exchange rate fluctuations.

False. PPP is a long-term theory and does not account for short-term market behaviors or capital flows.

What are the limitations of PPP?

Limitations include: - Differences in consumer preferences - Non-tradable goods - Local taxes and tariffs - Market imperfections

Question: How can PPP be tested?

By comparing the prices of a standardized basket of goods between two countries and calculating the implied exchange rate versus the actual exchange rate.

Calculate the implied PPP exchange rate: $200 in the US and ¥20,000 in Japan.

Implied PPP exchange rate = $200/¥20,000 = 0.01 USD/JPY.

What role does currency valuation play in PPP?

Currency valuation affects PPP as an overvalued currency can lead to higher local prices, distorting purchasing power compared to other currencies.

How does relative price change affect PPP?

If prices in one country rise faster than another, the currency of the faster-inflating country will depreciate in relative terms, in line with PPP theory.

Fill in the blank: A common method to measure PPP is through a _____ of goods.

basket

Fixed Exchange Rate

A system where a country's currency value is tied to another major currency. - Examples: Gold standard, Bretton Woods.

Floating Exchange Rate

This system allows currency values to fluctuate according to market forces, based on supply and demand.

True or False: Fixed rates eliminate currency risk.

True. Fixed rates reduce exchange rate risk for international transactions.

What determines exchange rate in a floating system?

Market supply and demand, interest rates, inflation rates, and economic indicators.

Pegged Exchange Rate

A currency value is maintained at a fixed rate to another currency or basket of currencies. - Allows for stability.

Cause → Effect: High inflation leads to...

...depreciation of the currency. - Consumers lose purchasing power in the foreign exchange market.

Currency Appreciation

An increase in the value of one currency compared to another, making imports cheaper and exports more expensive.

Fixed vs. Floating Exchange Rates: Key Difference

Fixed rates are government-set; floating rates are market-driven.

What is a currency board?

A monetary authority that maintains a fixed exchange rate by holding reserves in foreign currency.

Managed Float Exchange Rate

A hybrid system where the currency mostly floats but the government intervenes occasionally to stabilize.

Fill in the blank: A currency that is ___ is weak compared to others.

depreciating.

True or False: All countries use floating exchange rates.

False. Some countries use fixed or pegged systems.

Short Example: Impact of increased interest rates.

Higher interest attracts foreign capital, potentially leading to currency appreciation.

What is an exchange rate?

The price of one currency in terms of another. - Example: 1 USD = 0.85 EUR.

Nominal vs. Real Exchange Rate

Nominal is the current market rate; real adjusts nominal for inflation differences between countries.

Currency Depreciation

A decrease in the value of a currency relative to others, affecting import prices and export competitiveness.