Lecture International finance: An analytical approach (2/e) – Chapter 9: Purchasing power parity. The goals of this chapter are: To introduce the law of one price (LOP), to derive PPP from the LOP, to assess the empirical validity of PPP, to illustrate the PPP trading rule, to introduce the monetary model. | Chapter 9 Purchasing Power Parity Objectives To introduce the law of one price (LOP). To derive PPP from the LOP. To assess the empirical validity of PPP. To illustrate the PPP trading rule. To introduce the monetary model. Reasons for the Resurgence of Interest in PPP There is concern about the misalignment of exchange rates. PPP can be used as a trading rule. PPP is useful for corporate planning. PPP has implications for economic risk. The Law of One Price (LOP) In the absence of frictions, the price of a commodity expressed in a common currency must be the same in every country: From the LOP to PPP PPP as a Comparative Statics Relationship Deriving PPP from the S-D Model Deriving PPP from the S-D Model (cont.) The PPP Exchange Rate Derivation from PPP PPP and the Real Exchange Rate PPP and the Real Exchange Rate (cont.) PPP and the Real Exchange Rate (cont.) The Empirical Validity of PPP There is little empirical evidence to support the validity of PPP, particularly in the short run. There is some evidence for PPP under hyperinflation and over long periods of time. Actual and PPP Exchange Rates Actual and PPP Exchange Rates (cont.) Actual and PPP Exchange Rates (cont.) Actual and PPP Exchange Rates (cont.) Nominal and Real Exchange Rates Nominal and Real Exchange Rates (cont.) Nominal and Real Exchange Rates (cont.) Nominal and Real Exchange Rates (cont.) PPP as a Trading Rule Buy when and sell when The Monetary Model of Exchange Rates Predictions of the Monetary Model A monetary expansion leads to depreciation of the domestic currency. A rise in income leads to appreciation of the domestic currency. A rise in foreign prices leads to appreciation of the domestic currency. The Empirical Validity of the Monetary Model The model’s ability to explain and predict movements in exchange rates is unsatisfactory. It works well under hyperinflation. It is a useful tool for policy analysis and investment . | Chapter 9 Purchasing Power Parity Objectives To introduce the law of one price (LOP). To derive PPP from the LOP. To assess the empirical validity of PPP. To illustrate the PPP trading rule. To introduce the monetary model. Reasons for the Resurgence of Interest in PPP There is concern about the misalignment of exchange rates. PPP can be used as a trading rule. PPP is useful for corporate planning. PPP has implications for economic risk. The Law of One Price (LOP) In the absence of frictions, the price of a commodity expressed in a common currency must be the same in every country: From the LOP to PPP PPP as a Comparative Statics Relationship Deriving PPP from the S-D Model Deriving PPP from the S-D Model (cont.) The PPP Exchange Rate Derivation from PPP PPP and the Real Exchange Rate PPP and the Real Exchange Rate (cont.) PPP and the Real Exchange Rate (cont.) The Empirical Validity of PPP There is little empirical evidence to support the validity of PPP, particularly in the short .
