InternationalFinancialManagementBekaert2e.docx
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InternationalFinancialManagementBekaert2e.docx
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InternationalFinancialManagementBekaert2e
Chapter8
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:
Theterminologyof“overvalued”and“undervalued”referstotherelationshipoftheexchangeratetothePPPtheory.IftheactualexchangerateofeurosperpoundislessthanthePPPprediction,theeuroisovervaluedandthepoundisundervalued.WeknowthisisthecorrectanswerbecauseiftheactualexchangerateweretomovetothePPPprediction,theeurowouldhavetoweaken,andthepoundwouldcorrespondinglyhavetostrengthen,ontheforeignexchangemarket.Theweakeningoftheeurowouldcorrectitsovervaluation,andthestrengtheningofthepoundwouldcorrectitsundervaluation.
7.Whatmarketforcespreventabsolutepurchasingpowerparityfromholdinginrealeconomies?
Whichoftheserepresentunexploitedprofitopportunities?
Answer:
AnyoftheforcesthatcreateadeviationfromthelawofonepricecanalsocauseadeviationfromPPP.Seetheanswertoquestion4.Inaddition,evenifthelawofonepriceweresatisfiedforallgoods,iftheconsumptionbundlesinthetwocountriesputdifferentweightsonthegoodsbecauseoftastedifferencesacrosscountries,relativepricechangeswouldbereflectedindeviationsfromPPP.ItisouropinionthatdeviationsfromPPPdonotrepresentunexploitedprofitopportunities.
8.WhyisitbettertouseaPPPexchangeratetocompareincomesacrosscountriesthananactualexchangerate?
Answer:
Whencomparingincomesacrosscountries,oneisinterestedincomparingthequalityoflifethatoccursfromearningsuchincomesandconsuminginthosecountries.Onewaytodosuchacomparisonistoexaminetherealvaluesofthenominalincomes,thatis,tomultiplyeachofthenominalincomestimestherespectivepurchasingpowersofthecurrencies(whichisequivalenttodividingthenominalincomebythepricelevel).Therealvalueoftheincometellsyouthecommandovergoodsandservicesthatthenominalincomeprovideswhenyouconsumeinthatcountry.IftherealincomesincountriesAandBwerethesame,wewouldhave
IfwemultiplythisexpressionbythepricelevelincountryA,weget
Intheaboveexpression,theratioofthepricelevelincountryAtothepricelevelincountryBisthepurchasingpowerparityexchangerate.Hence,ifwemultiplythenominalincomeincountryBbythepurchasingpowerparityexchangeratewegetanominalincomethatisintheunitsofthecurrencyofcountryAandthatcanbecomparedtothenominalincomeincountryA.IfthenominalincomeincountryAishigherthanthepurchasingpowerexchangeratemultipliedbynominalincomeincountryB,peopleincountryAarebetteroffintermsoftheirabilitytoconsumethanthoseincountryB.
IfyouusetheactualexchangerateratherthanthePPPexchangeratetoconvertthenominalincomeincountryBintocurrencyofcountryA,youareeffectivelysayingyouwouldliketoearntheincomeincountryB,butyouwanttoconsumeitincountryA.Thiscancreateincorrectinferencesaboutwhereisthebestplacetolive.SupposecurrencyBisovervaluedrelativetoPPP.Then,themarketexchangerateofcurrencyAperunitofcurrencyB,denotedS,isgreaterthanthePPPprediction,
SPPP=
ThatisS>SPPP.Insuchasituation,itcanhappenthat
inwhichcaseweknowfromtheabovediscussionthatwewouldprefertoearnincomeincountryAandconsumethere.Yet,whenwecompareincomeswiththeactualexchangerate,wemightfindthatthe
TheovervaluationofcurrencyBcausesustothinkthattheincomeincountryBispreferred.But,thisisonlycorrectifweearntheincomeincountryBbutconsumeincountryAafterconvertingourincomeintothecurrencyofcountryA.
9.WhatisrelativePPP,andwhydoesitrepresentaweakerrelationshipbetweenexchangeratesandpricesthanabsolutePPP?
Answer:
ThetheoryofrelativePPPspecifiesthatexchangeratesadjustinresponsetodifferencesininflationratesacrosscountriestoleavethedeviationoftheactualexchangeratefromabsolutePPPunchanged.Intuitively,inflationistherateoflossoftheinternalpurchasingpowerofacurrency.Thus,iftwocurrenciesarelosinginternalpurchasingpoweratdifferentratesbecausetheratesofinflationinthetwocountriesarenotequal,therateofchangeoftheexchangeratecanoffsetthedifferentialratesofinflationtoleavethesameabsoluterelationshipbetweentheinternalandexternalpurchasingpowersofthecurrencies.TherelativePPPtheoryisweakerthanabsolutePPPbecauserelativePPPcouldbesatisfiedeventhoughtherearedeviationsfromabsolutePPP.TherequirementforrelativePPPtoholdisthatthedeviationsfromabsolutePPPdonotchangeovertime.
10.Whatistherealexchangerate,andhowarefluctuationsintherealexchangeraterelatedtodeviationsfromabsolutePPP?
Answer:
Therealexchangerate,say,ofthedollarrelativetotheeuro,isdenotedRS(t,$/€).Itisdefinedtobethenominalexchangeratemultipliedbyther
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