The document discusses the purchasing power parity (PPP) theory of exchange rates. PPP states that inflation rates should be reflected in changes in exchange rates to keep prices of identical goods equal across countries. It assumes the "law of one price," where identical goods have the same price globally excluding transaction costs. The theory was introduced in the 1920s as hyperinflation caused currency depreciation. Absolute PPP posits the exchange rate equals the ratio of price levels between countries. Deviations from absolute PPP can occur in real world markets.

1. Purchasing Power Parity

3. Spot Rate

4. Forward Rate

6. Purchasing Power

7. Inflation

8. Perfect or Efficient markets

10. Does inflation affect exchange rate?

11. If it does, how?

12. Does interest rate affect exchange rate?

13. If it does, how?

15. Purchasing Power Parity The PPP theory focuses on the inflation – exchange rate relationships. If the law of one price holds for all goods and services, we can obtain the theory of PPP. LAW OF ONE PRICE

16. Law Of One Price Law of one price states “ In an efficient all identical goods must have only one price” Identical goods should sell at identical prices in different markets If not, arbitrage opportunities exist Assumes that there will be no shipping costs, tariffs, taxes….etc. Relates to a particular commodity, security, asset etc..

18. Historical back drop A Swedish economist Gustav Cassel introduced the PPP theory in 1920s Countries like Germany, Hungary and Soviet Union experienced hyperinflation in those years due to World War I The purchasing power of these currencies declined sharply The currencies depreciated sharply against more stable currencies like the US dollar

19. Absolute PPP Law of one price extended to a basket of goods If the price of the basket in the U.S. rises relative to the price in Euros, the US dollar depreciates

20. Have a look If the price of the basket in the U.S. rises relative to the price in Euros, over a period of three days May 21 : s€/$ = P€ / PUS = 1235.75 € / $1482.07 = 0.8338 €/$ May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$ Has the US dollar appreciated or depreciated?

21. Mathematically , Absolute PPP postulates that Pais the general price level in country A Pbis the general price level in country B sa/bis the exchange rate between currency of country A and currency of country B sa/b = Pa / Pb

22. Statement The absolute PPP postulates that the equilibrium exchange rate between currencies of two countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar products of two countries should be equal when measured in a common currency as per the absolute version of PPP theory

23. Deviations from absolute PPP

24. Big Mac and PPP