Parity Conditions in International Finance International Finance (MB 74)

Outline Purchasing Power Parity International Fisher Effect Interest Rate Parity

Purchasing Power Parity (PPP) Absolute Version Individual goods and services tend to sell for the same price everywhere. If prices differ, arbitrage would take place which would change the price and/or the exchange rates to force an equilibrium Relative Version The rate of change in the prices of the products should be somewhat similar when measured in a common currency

PPP Continued… The exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. If I home > I foreign, foreign currency must appreciate relative to home currency to offset the advantage of more buying power of home currency. Similarly, if I home < I foreign, foreign currency must depreciate relative to home currency to offset the advantage of more buying power of foreign currency. US Inflation = 4% Japanese Inflation = 2% The dollar value of yen must rise by 2%

Some Lessons of PPP Exchange Rate Changes may indicate nothing more than the reality that countries have different inflation rates Exchange rate movements should cancel out changes in the foreign price level relative to the domestic price level with no effect on the relative competitive position of domestic firms and their foreign counterparts In terms of currency changes affecting relative competitiveness, the focus must not be on nominal exchange rate changes, but instead on the real purchasing power of one currency relative to the other currency If changes in nominal exchange rates are fully offset by changes in the relative price levels, then the real exchange rate remains unchanged Important implications for exchange rate risk management

If PPP holds, real exchange rate will not change—no effect on competitive strength Deviation from PPP, however, will lead real exchange gains and losses

Why PPP fails to hold? Sticky nature of Goods Prices Different Price Indices Changes in Relative Price levels Composition of the Price Indices