Question

1) Suppose the cost of basket is P_eu = 300 euros in the Eurozone and P_Turkey =800 liras in Turkey. Suppose the home country is Turkey, and the exchange rate is 1.8 liras per euro.

a) Write the absolute purchasing power parity (PPP) equation. Check to see whether PPP holds for the lira-euro exchange rate.

b) Calculate the real exchange rate. Determine whether lira is over-valued, under-valued or neither.

c) Write two reasons for why the tendency for PPP to hold is weak in the short-run.لا

Answer 1

a) Absolute Purchasing Power Parity equation,

PTurkey / Peu = ELira/Euro

=> Pturkey/Peu = 800/300 = 2.667

And ELira/Euro = 1.8 which is not equal to 2.667

Thus, PPP doesn’t hold for the Lira-Euro exchange rate.

b) Real Exchage rate(R) = ELira/Euro*PEu/PTurkey

=> R = 1.8*300/800 = 0.5625

As, the real exhange of lira to euro is less than 1(=0.5625), so, Turkish Lira is overvalued and should depriciate. Or another method is that because exchange rate in PPP terms is more than spot exchange rate, so, Turkish Lira is overvalued and should depriciate.

c) PPP method works on arbitrage i.e. the currency which is overvalued is supplied more and which is undervalued is demanded more causing the exchange rate to reach the real rate. But in short run, transaction cost and other such cost may not lead to arbitrage because profits from arbitrage may not be more than transaction cost, so, arbitrage may not occur and hence, PPP won’t hold. Also, the basket of goods may not have same weights in the two countries and it also may be the case that all the goods are not traded between the two countries to give an arbitrage opportunities to arbitragers leading to convergence of spot exchange rate and real exchange rate

*Please don’t forget to hit the thumbs up button, if you find the answer helpful.