Purchasing Power Parity is based on the law of one price across the globe. The theory continuously adjusts exchange rates between countries in order to denote the purchasing power of each country. If a country’s inflation is very high then that country may devalue its currency to equalize the Purchasing Power Parity. PPP cannot effectively determine factors such as the actual currency exchange rate, the GDP and the living standards of a country.
Assume: 1 USD = 49.25
Inflation (India) = .7%
Inflation (US) = .2%
Interest Rate (India) = 6%
Interest Rate (US) = .22%
ABSOLUTE PPP OR THE LAW OF ONE PRICE
Re. Price of a commodity = Price of 1 USD in rupee terms * USD price of commodity
E.G: If a apple cost $2 in the US, then according to this law, the price in India would be:
Spot Exchange Rate = 1USD: Rs. 49.25
Rs. 49.25*$2 = Rs. 98.5
RELATIVE PPP
The Relative PPP theory overcomes the limitation of the Absolute PPP theory by considering changes in the ratio of the price indices in the US and India and relating this changes to the exchange rate. Thus under this theory, the percentage change in the exchange rate should equal the percentage in the ratio of the price indices of the two countries.
Spot Exchange Rate at time t = Value of Country A’s currency in terms of Country B at the beginning of the period*(Inflation Rate of Country A / Inflation Rate of Country B) ^ (t)
Where I is the number of time periods in consideration.
Thus given 1USD = Rs.49.25
Inflation (India) = .7%
Inflation (US)=.2%
The value of the rupee in a two year period, for example, would be:
e2 = 49.25* (1.007/1.002)^(2)
= Rs.49.743/US $
INTEREST RATE PARITY THEORY
The Interest Rate Parity Theory states that equilibrium is achieved when the forward rate differential is approximately equal to the interest rate differentials between the two countries.
Thus according to this theory, the country with a higher interest rate would have a lower forward exchange rate value in order to prevent arbitrage.
Thus given: 1 USD = Rs. 49.25
Interest Rate (India)= 0.06%
Interest Rate (US) = 0.0022%
1 + i /+i* = F (0,1)/S(0)
Where 1+i is the Indian Interest Rate and 1+i* is the US Interest Rate. F (0,1) is the forward rate given a one-year period. S (0) is the spot exchange rate at time 0.
Thus the one-year forward rate for the Rupee would be given by:
F (0,1) = (1.06/1.0022)*49.25
= Rs. 52.09/US$
Assume: 1 USD = 49.25
Inflation (India) = .7%
Inflation (US) = .2%
Interest Rate (India) = 6%
Interest Rate (US) = .22%
ABSOLUTE PPP OR THE LAW OF ONE PRICE
Re. Price of a commodity = Price of 1 USD in rupee terms * USD price of commodity
E.G: If a apple cost $2 in the US, then according to this law, the price in India would be:
Spot Exchange Rate = 1USD: Rs. 49.25
Rs. 49.25*$2 = Rs. 98.5
RELATIVE PPP
The Relative PPP theory overcomes the limitation of the Absolute PPP theory by considering changes in the ratio of the price indices in the US and India and relating this changes to the exchange rate. Thus under this theory, the percentage change in the exchange rate should equal the percentage in the ratio of the price indices of the two countries.
Spot Exchange Rate at time t = Value of Country A’s currency in terms of Country B at the beginning of the period*(Inflation Rate of Country A / Inflation Rate of Country B) ^ (t)
Where I is the number of time periods in consideration.
Thus given 1USD = Rs.49.25
Inflation (India) = .7%
Inflation (US)=.2%
The value of the rupee in a two year period, for example, would be:
e2 = 49.25* (1.007/1.002)^(2)
= Rs.49.743/US $
INTEREST RATE PARITY THEORY
The Interest Rate Parity Theory states that equilibrium is achieved when the forward rate differential is approximately equal to the interest rate differentials between the two countries.
Thus according to this theory, the country with a higher interest rate would have a lower forward exchange rate value in order to prevent arbitrage.
Thus given: 1 USD = Rs. 49.25
Interest Rate (India)= 0.06%
Interest Rate (US) = 0.0022%
1 + i /+i* = F (0,1)/S(0)
Where 1+i is the Indian Interest Rate and 1+i* is the US Interest Rate. F (0,1) is the forward rate given a one-year period. S (0) is the spot exchange rate at time 0.
Thus the one-year forward rate for the Rupee would be given by:
F (0,1) = (1.06/1.0022)*49.25
= Rs. 52.09/US$
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