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Purchasing Power Parity (PPP) | Finance Train

Economics

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CFA Level 2: Economics - Introduction

Economic Growth

Changes in Productivity: The One-Third Rule

The Productivity Curve

Economic Growth Theories

Government Regulation, Deregulation, and Regulatory Behaviour

Gross Domestic Product (Measuring Economic Activity)

International Trade & Trade Restrictions

Balance of Payments

Foreign Exchange Rate Systems and Parity Relationships

Foreign Exchange Floating Rate Systems

Fixed Exchange Rate Systems

Overview of Currency Markets

Forward Exchange Rates

Interest Rate Parity

Purchasing Power Parity (PPP)

International Fisher Relation

Uncovered and Covered Interest Rate Parity Relationship

Forecasting Exchange Rates

CFA Level 2 Economics – Recommendations

Lesson 16 of 20

Purchasing Power Parity (PPP)

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PPP theoretically links the movements in exchange rates between two countries to the changes in their currencies’ respective purchasing power.
The Law of One Price – if there are no transportation costs, then an identical good should trade at an identical real price anywhere in the world.
Absolute PPP – based on the law of one price, absolute PPP postulates that the spot exchange rate should reflect the price of one good compared to the other.

S X/Y = PriceX/PriceY

Relative PPP – rooted in inflation rates, relative PPP theorizes that the future period spot rate is a function of the current spot rate (S0) and inflation (I) rates until the future spot (S1).

S 1 X/Y = S 0 X/Y ((1 + IX period)/(1 + IYperiod))

The PPP applications assume common generalities in order to compare the currencies of vastly different economies and cannot fully explain reality.