Notes on Purchasing Power Parity (PPP) and Exchange Rates

Key Concepts of Purchasing Power Parity (PPP) and Exchange Rates

Relative Change in Inflation

• Definition: Relative change between domestic inflation and foreign inflation is crucial in determining currency value.
  • If domestic inflation > foreign inflation, the domestic currency should depreciate.
  • If domestic inflation < foreign inflation, the domestic currency should appreciate.

Absolute vs. Relative PPP

• Implication of PPP: Nominal exchange rates adjust to maintain the real exchange rate.
  • Higher inflation in a country typically leads to a depreciated currency.

Hyperinflation Explained

• Definition: A scenario characterized by extremely high and typically accelerating inflation (more than 50% per month or over 10,000% per year).
  • Results from excessive money printing by the government.
  • Impacts both domestic and international value perception of currency leading to depreciation.
• Historical Example: Germany post-World War I saw hyperinflation and a significant drop in the value of the Deutsche Mark.
  • Government printed excessive amounts of money to pay reparations, causing severe inflation.
  • Consequence: Prices rose drastically, and the currency became almost worthless (e.g., needing enormous amounts of currency to buy basic goods).

Impact of Money Supply

• Graphical Representation: Money supply increases significantly correlate with price level increases, leading to a depreciated currency.
• Consumers’ desire to hold the currency decreases, reflecting in international currency value.

The Big Mac Index as a Fun Measure of PPP

• Concept: The Economist magazine uses the Big Mac as a benchmark to compare prices across countries.
  • Big Macs are available globally and have standardized ingredients, making it easier to draw comparisons.
• Application: If a Big Mac costs $5.65 in the US, it should cost roughly the same elsewhere, based on PPP. Discrepancies indicate variations in currency values and living costs.

The Limitations of PPP

• Theoretical Boundaries: Though PPP provides a guideline, it is not perfectly accurate due to:
  • Arbitrage Limitations: Real-world barriers such as tariffs, transportation costs, and differences in preferences impede perfect arbitrage.
  • Product Differences: Not all goods/services are perfect substitutes; regional preferences lead to price variance.

Relative vs. Absolute PPP

• Relative PPP: Empirical data suggests it holds truer over time. Price level comparisons between countries affect nominal exchange rates.
  • A 1% increase in price levels often corresponds with approximately a 1% decrease in nominal exchange rates.

Practical Applications of PPP

• Cost of Living Comparison: Adjusted GDP per capita using PPP can provide a clearer picture of living standards.
  • Example: $10,000 in Mexico may equate to $20,000 in the US considering price levels.
• Conclusion: While PPP is not flawless, it allows for comparison of economic metrics across countries, enabling better analysis of real living standards and economic health.

Final Notes

• Further Study: Important to review Chapter 13 to prepare for further discussion on international capital and exchange rates in upcoming classes.