Purchasing Power Parity (PPP)

Definition: real value of the amount of goods and services that can be purchased with a given amount of money; links exchange rates to the prices of goods in different countries.

Why you should study this theory? 

1. Provide a base line forecast of future exchange rates in order to forecast future cash flows in different currencies, especially when inflation is differ.
2. Play a fundamental role in corporate decision making, such as: international location of manufacturing plants, pricing products and other int'l capital budgeting issues.
3. Assessing cost of living differences across countries.

Price level -- a weighted average of the prices of the goods and services that people consume, providing information about the purchasing power of a currency.

Price index -- the ratio of a price level at one point in time to the price level in a designed base year, providing information about the rate of inflation between two point of time.

Absolute Purchasing Power Parity -- states that the exchange rate will adjust to equalise the internal and external purchasing power of a currency. Internal: the amount of goods and services that can be purchased with $1 inside the US, external: $1 outside the US. Overvalued: external > internal; Undervalued: External < Internal.
The failure of Absolute PPP: changes in relative prices due to different weights; non-traded goods (houses, technology/productive improvement).

Relative Purchasing Power Parity -- takes market imperfections into account, exchange rates adjust in response to differences in inflation across countries.

Law of One Price -- equivalent goods should sell for the same price in everywhere. Big Mac should cost the same (once you convert money) no matter where you go. Violations of the law of One Price: Tariffs and quotas; transaction costs; difficult in finding buyers for the same goods; Non-competitive markets; sticky prices (high cost for switching prices "menu cost").