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Chapter 15: Price Levels and the Exchange Rate in the Long Run
Purchasing Power Parity (PPP)
Purchasing power parity: the idea that exchange rates are determined by the amount
of different currencies required to purchase a representative bundle of goods. In other
words, it is the concept that explains movements in the exchange rate between two
currencies by changes in the countries’ price levels.
When PPP holds, an individual will be indifferent in buying an identical good at
home or abroad because it will cost the same amount of money in different countries
when measured in the same currency.
Absolute Purchasing Power Parity (APPP)
It is the form of PPP stated in terms of levels of prices and level of exchange rate.
More formally, APPP tells us that in the absence of frictions such as transportation
costs, tariffs and others, it should cost the same amount of money to purchase an
identical basket of goods in different countries when expressed in the same currency
In notation form, APPP can be expressed as:
Let: P = # of DC per basket of goods at home
P* = # of FC per basket goods abroad
PPP implies:
P = EDC/FC × P*
*
P
P
E
=
Relative Purchasing Power Parity (RPPP)
It is the form of PPP stated in terms of inflation rates and changes in exchange rates.
RPPP tells that percentage change in the exchange rate between two currencies over
any period equals to the inflation rate differentials between the two countries.
In notation form, RPPP can be expressed as:
ECMC61 – Chapter 15 1
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*
E
E
e
E
=
ECMC61 – Chapter 15 2
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Implication: RPPP tells us that the rate of a country’s currency depreciates by the
excess of its inflation over that of another country.
Refer to page 385 of the text for formal derivation of RPPP.
A Long-Run Exchange Rate Model Based on PPP (The Monetary Approach to the
Exchange Rate)
The Monetary approach to the exchange rate: a model of exchange rate
determination which shows factors that do not influence money supply and money
demand do not play an explicit role in determining the exchange rate.
The Fundamental Equation of the Monetary Approach
Assumptions:
1) PPP holds continuously, i.e.,
*
P
P
E
=
.
2) A stable money demand function in both countries: L(R, Y) and L*(R*,
Y*).
3) Money market is always in equilibrium and prices are fully flexible. Thus,
Y) (R, L
MS
P
=
and
Y*) (R*, *L
*
MS
*
P
=
Given these assumptions, equilibrium exchange rate is
( ) ( )
===
YR,L
*
Y,
*
R
*
L
*
MS
MS
*
Y,
*
R
*
L
*
MS
YR,LMS
*
P
P
E
It shows that exchange rate is fully determined by the relative supplies of monies and
the relative real demands for monies.
ECMC61 – Chapter 15 3
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