Parity in International Finance

ByPavan Mandowara

Purchasing Power Parity

PPP Theory developed by Gustav Cassell, a Swedish Economist in 1900’s.

Describes the relationship between average price levels in a country & its exchange rates.

Follows a Law of one price. A unit of home currency should have

same purchasing power in all countries.

Law of one price

A product or a commodity can be sold in two different markets, its price should be same in both the markets, given No transportation cost No transaction cost No tariffs No restrictions on movements of goods No product differentiation Absolute free flow of information.

2 versions of PPP

Absolute Version

Relative Version

Absolute PPP

A Product can be sold in 2 different market, price in terms of common currency should be same in both market,

It is applicable even in a basket of products or services.

If the price in both market in common currency is not same, arbitration opportunity exists.

1st Nov 2010, 1 kg Apple in India is Rs 45, in America is $1.

So $1 = 45/1 = Rs 45. On 15th Nov, 2010 Apple in India is

Rs 40 and in US it is $0.95, So, 1$ = 40/0.95 = Rs 42. If the exchange rate is 1$ = Rs 43,

arbitration opportunity exists.

A Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Base year is 2004-05. 676 commodities. Current Inflation is 9.82%.

Consumer Price Index (CPI): - A measure that examines the weighted average of prices of a basket of consumer goods and services.

Relative PPP

Rates of Inflation are considered better determination of Exchange Rates.

RPPT says that %change in exchange rates between 2 countries should be equal to % change in ratio of price indexes in 2 countries.

Currency of country with higher inflation should depreciate relatively to another country’s currency having lower depreciation.

1st Nov 2010, WPI in India is 200 and CPI in US is 100. 1$ = Rs 44

Now on 31st Dec. 2010 WPI is 216 and CPI is 105. Calculate the Exchange rate according to PPP

WPI rose by 8% and CPI by 5%. So Rs should be depreciated by

(1.08/1.05)-1 = .0286 * 100 = 2.86%. 44 * 1.0286 = 45.2584. So on 31st Dec $1=Rs 45.2584.

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