Introduction

This Chapter discusses the Purchasing Power Parity (PPP) theorem, a fundamental concept in international finance. The PPP theorem provides insights into the relationship between exchange rates and relative price levels between two countries. Understanding PPP is essential for analyzing foreign exchange rates, inflation differentials, and the long-term behavior of currencies. This chapter explores the concept of PPP, its implications, and how it can be used to calculate the appreciation or depreciation of a foreign currency.

Understanding the Purchasing Power Parity (PPP) Theorem

The Purchasing Power Parity theorem is based on the idea that in the long run, exchange rates should adjust to equalize the purchasing power of different currencies. In simpler terms, it suggests that a unit of currency in one country should have the same purchasing power as the same unit of currency in another country. This equilibrium exchange rate is often referred to as the “PPP exchange rate”.

Calculating Foreign Currency Appreciation/Depreciation using PPP

To calculate the appreciation or depreciation of a foreign currency using PPP, we compare the current exchange rate with the PPP exchange rate. The formula for calculating the percentage change in the foreign currency’s value is as follows:

$$\text{Percentage Change }= \dfrac{\text{(Current Exchange Rate - PPP Exchange Rate)}}{\text{PPP Exchange Rate}} \times 100$$

If the calculated percentage change is positive, it indicates that the foreign currency is appreciating relative to the base currency, and if it is negative, it suggests depreciation.

Example: Let’s consider an example to understand the application of the PPP theorem. Assume that the current exchange rate between the US dollar (USD) and the Euro (EUR) is 1 USD = 0.85 EUR. The PPP exchange rate, based on relative price levels between the US and the Eurozone, is determined to be 1 USD = 0.90 EUR.

$$\text{Percentage Change }= \dfrac{(0.85-0.90)}{0.90} \times 100 = -5.56 \%$$

In this example, the percentage change is negative (-5.56%), indicating that the US dollar has depreciated relative to the Euro according to the PPP theorem.

Limitations of the Purchasing Power Parity (PPP) Theorem

While the PPP theorem provides valuable insights into long-term currency movements, it has several limitations. One significant limitation is that PPP often does not hold in the short run due to various factors such as market inefficiencies, trade barriers, and capital flows. Additionally, the PPP theorem assumes that goods are perfectly tradable between countries, which is not always the case. Therefore, actual exchange rates may deviate from the PPP exchange rate for extended periods.