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Purchasing Power Parity (PPP) is the notion that the ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies. PPP theory takes two basic forms: The absolute form, also called the law of one price, suggests that prices of similar products of two different countries should be equal when measured in a common currency. The relative form of PPP is an alternative version that accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas.
(1 I ) h 1 (1 I ) f
e f Ih If
That is, the exchange rate percentage change should be approximately equal to the differential in inflation rates between two countries.
(1 i ) h 1 (1 i ) f
ef ih if
That is, the exchange rate percentage change should be approximately equal to the interest rate differential between two countries.
Theory
Interest rate parity Forward rate Premium (or discount) Purchasing power % change in parity (PPP) spot exchange rate International % change in Fisher Effect (IFE) spot exchange rate
Practical Problems
1. Assume that the Canadian dollars spot rate is $.85 and that the Canadian US inflation rates are similar. Then assume that the Canadian experiences 4 % inflation, while the US experiences 3 % inflation . According to PPP, what will be the new value of the C$ after it adjusts to the inflationary changes? Australian dollars spot rate is $.90 and that Australian and US one year interest rates were initially 6 %. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the US one-year interest rate remains unchanged. Using this information and the IFE theory, forecast spot rate for one-year ahead.
2.