International-Financial-Management---Bekaert-2e---Solutions---Ch08.doc
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Chapter8:
PurchasingPowerParityandRealExchangeRates
Chapter 8
PurchasingPowerParityandRealExchangeRates
QUESTIONS
1.Whatdoesthepurchasingpowerofamoneymean?
Howcanitbemeasured?
Answer:
Thepurchasingpowerofamoneyisalsoknownasitsrealvalueandindicatestheamountofgoodsandservicesthatcanbepurchasedwithagivenamountofthemoney.Wemeasurepurchasingpowerbyfirstcalculatingthepricelevel,whichisaweightedaverageofthepricesofthegoodsandservicesthatpeopleconsume.Theweightsinthepricelevelreflectthesharesofthesegoodsandservicesintheconsumptionbundleofatypicalindividual.Thepurchasingpowerofthemoneyisthenfoundbytakingthereciprocalofthepricelevel.Theunitsofthepricelevelareanamountofmoneyperconsumptionbundle,andtheunitsofpurchasingpowerareconsumptionbundlesperunitofmoney.
2.Supposethegovernmentreleasesinformationthatcausespeopletoexpectthatthepurchasingpowerofamoneyinthefuturewillbelessthantheypreviouslyhadexpected.Whatwillhappentotheexchangeratetoday?
Why?
Answer:
Typically,whenpeoplethinkthatthepurchasingpowerofamoneyisgoingtodeclineinthefuture,duetohigherexpectedinflation,theytrytosellthatcurrencytodaytogetintoacurrencythatwillhavemorestablepurchasingpower.Thisreduceddemandforthecurrencycausesthatcurrencytoweakenordepreciateimmediately.
3.Whatisthedifferencebetweenapricelevelandapriceindex?
Answer:
Thepricelevelisaweightedaverageofthepricesofthegoodsandservicesthatpeopleconsume.Thepriceindexisaratioofapricelevelatonepointintimetothepricelevelinsomebaseyear,withtheratiousuallymultipliedby100.Thus,ifthepricelevelinagivenyearis30%higherthanthepricelevelinthebaseyear,thepriceindexwouldbe130.Pricelevelsgiveyouinformationaboutthepurchasingpowerofacurrency.Priceindexesgiveyouinformationabouttherateofinflationbetweentwopointsintime.
4.Whatdoeconomistsmeanbythelawofoneprice?
Whymightthelawofonepricebeviolated?
Answer:
Thelawofonepricesaysthatthepriceofagood,whendenominatedinaparticularcurrency,isthesamewhereverintheworldthegoodisbeingsold.Thelawofonepricereliesonarbitrageinthegoodsmarket.Ifthegoodisbeingsoldinoneplaceatalowpriceandisbeingsoldinadifferentplaceatahighprice,peoplehaveanincentivetoarbitragethetwomarkets.Therefore,anythingthatmakesitdifficultorcostlytoarbitrageinthegoodsmarketcancreateadeviationfromthelawofoneprice.Clearly,transactioncosts,suchasthecostsofshipping,generatedeviationsfromthelawofonepricethatcannotbearbitraged.Tariffsandquotasonimportsandexportsalsocreatedeviations.Ifmarketsarenotcompetitiveandfirmshavesomemonopolypower,thecorporationmaydecidetochargedifferentpricesindifferentcountries,butitmustbeabletosegmentthemarketstopreventarbitrage.Ifarbitragecannotbedoneinstantaneously,therewillbeaspeculativeelementthatentersthecalculationsandthespeculatormayhavetobecompensatedfortheriskoflosswithanexpectedprofitfrombuyinginonemarketandsellinginanothermarketatalaterpointintime.Finally,variousgoodsmarketsaresubjecttoacertainamountofpricestickinessbecauseofthecostsofchangingprices.Becauseexchangeratesareassetpricesandfreelyflexible,unanticipatedchangesinexchangerateswillcreatedeviationsfromthelawofonepriceifgoodspricesaresticky.
5.WhatisthevalueoftheexchangeratethatsatisfiesabsolutePPP?
Answer:
Absolutepurchasingpowerparityrequiresthattheinternalpurchasingpowerofacurrencyequalsitsexternalpurchasingpower.Theinternalpurchasingpoweriscalculatedbytakingthereciprocalofthepricelevel,andtheexternalpurchasingpoweriscalculatedbyfirstexchangingthedomesticmoneyintotheforeignmoneyintheforeignexchangemarketandthencalculatingthepurchasingpowerofthatamountofforeigncurrencyintheforeigncountry.Hence,thepredictionofabsolutePPPfortheexchangerateofdomesticcurrencyperunitofforeigncurrencyisfoundbyequatingtheinternalpurchasingpowerofthedomesticcurrencytotheexternalpurchasingpowerofthedomesticcurrency:
whereP(DC)isthedomesticpricelevel,P(FC)istheforeignpricelevel,andSPPPsignifiestheexchangerateofdomesticcurrencyperunitofforeigncurrencythatsatisfiesthePPPrelation.BysolvingforSPPP,wefind
6.IftheactualexchangeratefortheeurovalueoftheBritishpoundislessthantheexchangeratethatwouldsatisfyabsolutePPP,whichofthecurrenciesisovervaluedandwhichisundervalued?
Why?
Answer:
Thetermin