Lecture 14
PURCHASING POWER PARITY

Key concepts

• Law of one price
• Purchasing power parity
• Fisher effect
• Real and nominal exchange rates

1. Law of one price (for a good)

• The prices of a good in two countries are the same, when expressed in the same currency

• No trade barriers
• No transport costs

2. The theory of PPP

• Absolute PPP
• A basket of commodities will cost the same in two countries in terms of a single currency:
  P_US = E_$/yen x P_J
• Relative PPP
• Rate of change of exchange rate equals the difference in inflation in the two countries:
  US inflation rate = Japan's inflation rate + Rate of depreciation of the dollar

• The country with the higher rate of inflation will experience a depreciating currency
• The Big Mac Index
• The Economist tracks the price of a Big Mac in different cities
• Provides an indication about the overvaluation or undervaluation of a currency

3. Fisher effect

• Use interest parity condition along with relative PPP
• Interest-rate differential = Difference in inflation rates:
• Real interest rates are equal across countries
• Empirical evidence suggests that interest rates and inflation move together in the long run

4. The Real Exchange Rate (q)

• Definition:   q_$/yen = E_$/yen P_J / P_US
• Represents the purchasing power of a $ in the U.S. relative to its purchasing power in Japan
• Increase in q means a real depreciation of the $

• Effect of a real dollar depreciation on US exports and imports?