The theory of Purchasing Power Parity postulates that foreign exchange rates should be evaluated by the relative prices of a similar basket of goods between. Examines the interest rate and purchasing power parities between countries. Interest Applications · Foreign Exchange Parity Relations · Purchasing power parity (PPP) is an economic theory that compares that after accounting for differences in interest rates and exchange rates, the cost of The relative version of PPP is calculated with the following formula.
If price changes are not too large, then approx. Import tariffs and quotas can cause static PPP violations. Many items cannot be traded such as on-site services haircutsperishable goods, etc. Hence PPP measured with standard price indexes can be violated.
Movement of buyers can compensate for movement of goods, sometimes. Movement of producers can also compensate.
Purchasing Power Parity Interest Rate Parity
Producers will move to places where the goods price is high. In the long run, PPP should hold even if there are non-traded goods. If the forward rate is greater than the expected future spot rate, then speculators will sell the foreign currency forward.
If the forward rate is lower than the expected future spot rate, then they will buy forward contracts on the foreign currency. Putting this together with the covered interest rate parity condition, we derive the uncovered interest rate parity condition also known as the International Fisher Equation: Viswanath 11 Deviations from Covered Interest Parity Although covered interest parity generally holds, there could be deviations because of: The Big Mac PPP exchange rate between two countries is calculated by dividing the cost of a Big Mac in one country in its own currency by the cost of a Big Mac in the other country in its own currency.
Purchasing Power Parity and Interest Rate Parity theories
The resulting value is usually compared with the current exchange rate. In case the value is lower, then the first currency appears to be undervalued in comparison with the second currency.
In case the value is higher, then the first currency appears to be overvalued in comparison with the second. Let us have an example. The implied purchasing power parity is calculated as follows: Therefore, the parity was 1.
Comparing both values we reach the following result: Data is shown in the form of a table, containing price levels for major industrialized countries.
Every column shows the number of monetary units needed in every country in order to purchase the same sample basket of consumer goods and services.
Limited application The theory of Purchasing Power Parity should be applied only for fundamental analysis in a long term. Forces behind Purchasing Power Parity will at some point equalize the purchasing power of currencies.