Thomas Lypps 20232722 March 10, 2010
Purchasing Power Parity (PPP) is the ‘ideal’ that price levels in any two countries should be the same
after the transfer/exchange of currency for trade. It is considered an ideal because it makes sense in a
theoretical sense but in a practice it does not hold. PPP tends to fail because of three main things: non-
traded goods, pricing to the market, and trade barriers.
The basis to PPP is the Law of One Price, “abstracting from complicating factors such as transportation
costs, taxes, and tariffs, the law of one price states that any good that is traded on world markets will
sell for the same price in every country engaged in trade, when prices are expressed in a common
Relative PPP is based on the relative consumption and/or production of a given country. For example,
Canadians may like to eat more blueberries than Britain, in which case, by supply and demand, they
would be more expensive in Canada than in Britain if the production factors where the same.
Interest rate parity is one of the other reasons why PPP does not hold, because of its influence in non-
tradable goods, where a party is able to have a covered investment. It is considered covered because
“Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency,
exchanging that currency for another currency and investing in interest-bearing instruments of the second
currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the
holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments
of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free
The uncovered side of the interest rate parity is called the International Fisher Effect, where the future
nominal exchange rates is predicted by the difference of nominal interest rates in the two countries,
assuming the currency of the country with the lower nominal interest rate will increase in value. Where
essentially it becomes true arbitrage where money is being traded across markets to profit from the
difference in conversions and using interest rates as a predictor of future currency movement.
Considering a countries currency, there is an Impossible Trinity where a country can only have a
combination of any two factors and not all three. These factors are free capital flow, sovereign
monetary policy, and/or a fixed exchange rate. Given any two, it is not possible to have the third
regardless of the policies and procedures put into place.
Although PPP serves as a useful way of thinking about foreign exchange markets, because of the
external factors affecting it, its failure to be upheld proves it to be a poor predictor. Considering non-
traded goods, pricing to the market, and trade barriers, predicting through practical application, we can
see how there are discrepancies in the foreign exchange market.
1 Burgernomics: A Big Mac™ Guide to Purchasing Power Parity, Michael R. Pakko and Patricia S. Pollard,
2 Wikipedia, Interest rate parity, accessed 07/03/10,