L17-18: Purchasing power parity

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Flashcards covering Purchasing Power Parity, Real Exchange Rates, Balassa-Samuelson Hypothesis, and Financial Markets in Open Economy.

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18 Terms

1
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What is Purchasing Power Parity (PPP)?

PPP means that the price of something should be the same everywhere if you convert the currencies. So, if a widget costs $1 in the US, it should cost the same in Euros in Europe, after you change the Euros back to dollars. This idea comes from the 'law of one price'.

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What does Absolute Purchasing Power Parity (APPP) state?

APPP (P = SP*) states that the general level of prices, when converted to a common currency, will be the same in every country. This means that exchange rates will adjust so that identical goods cost the same globally, leading to no arbitrage opportunities.

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How is the Consumer Price Index (CPI) defined in the context of PPP?

CPI measures the average price of goods and services people buy. The importance of each item is based on how much people spend on it. If spending patterns are the same across countries, we can compare prices directly using the formula P = SP*.

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Why is PPP an important benchmark?

PPP serves as an important benchmark for analyzing exchange rate movements, suggesting that competitiveness is equalized across countries when PPP holds.

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According to PPP, what does it mean if the actual exchange rate between the USD and GBP is 1 USD = 0.9 GBP, and the PPP exchange rate is 1 USD = 0.75 GBP?

It suggests that the pound is undervalued and needs to appreciate. This difference indicates that goods in the UK are cheaper compared to the US, implying a potential increase in demand for GBP and a future adjustment in the exchange rate to reach parity.

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According to PPP, what does it mean if the actual exchange rate between the USD and GBP is 1 USD = 0.5 GBP, and the PPP exchange rate is 1 USD = 0.75 GBP?

It suggests that the pound is overvalued and needs to depreciate. This indicates that the dollar can buy more pounds in comparison to what would be expected based on purchasing power parity, implying the GBP is currently overvalued relative to the USD.

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What are the implications of an undervalued pound?

An undervalued pound makes exports cheaper in foreign markets and imports more expensive for domestic households.

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What does the Real Exchange Rate (Q) measure, and how is it calculated?

The Real Exchange Rate (Q = SP*/P) measures the value of domestic goods compared to foreign goods, adjusting for price level differences.

It is calculated by taking the nominal exchange rate (S), the price level of foreign goods (P), and the domestic price level (P). The formula Q = SP/P indicates how many foreign goods can be purchased with a unit of domestic goods.

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What should be the value of the Real Exchange Rate (Q) if APPP holds?

If APPP holds, the value of Q should equal one.

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What is the Relative Purchasing Power Parity equation?

dp – dp* = ds, where dp and dp* are the inflation rates in the domestic and foreign countries respectively, and ds is the change in the exchange rate.

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What does Relative PPP state about the relationship between inflation and exchange rates?

When the domestic country has a higher inflation rate than the foreign country, its exchange rate should depreciate.

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How can the Absolute PPP equation be modified to account for transaction costs such as tariffs and transportation costs?

The Absolute PPP equation can be modified to P = K(SP*), where K represents the proportional transaction costs.

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What is the Balassa-Samuelson hypothesis?

The Balassa-Samuelson hypothesis states that productivity increases in the traded goods sector lead to higher wages in both traded and non-traded sectors, causing the overall price level to rise, particularly in wealthier countries. It suggests that the general price level will be higher in rich countries because of the higher price of non-tradeable services.

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What does the Balassa-Samuelson hypothesis predict for fast-growing developing countries?

The B-S hypothesis predicts that fast-growing developing countries (like China) should experience an appreciation of their currency. This appreciation occurs because rising productivity in the traded goods sector increases wages, which then raises the overall price level.

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Why are PPP exchange rates not a suitable benchmark for comparing exchange rates between a developed country and a developing country?

PPP exchange rates are not suitable because the Balassa-Samuelson hypothesis suggests that the price level will be proportional to per-capita income, aka richer countries usually have higher prices due to things like higher wages, especially in non-tradeable sectors like services

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What is uncovered interest rate parity (UIP)?

UIP says that the interest rate in one country should be about the same as the interest rate in another country, once you consider how much the money is expected to change in value (depreciate). So, if a country's currency is expected to weaken, its interest rates need to be higher to make up for that risk.

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What is covered interest parity?

A financial theory stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies, ensuring no arbitrage opportunities exist.

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What is the carry trade paradox, and why does it challenge the uncovered interest rate parity (UIP) theory?

The carry trade paradox refers to the observation that borrowing in a low-interest-rate currency and investing in a high-interest-rate currency can be profitable, despite UIP suggesting that high-interest-rate currencies should depreciate.