Question

Give an example of why under purchasing power parity a change in nominal exchange rate does not affect a firm or country.

Answer 1

The purchasing power parity (PPP) states that the exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries. The exchange rate must change to adjust to the change in the prices if goods in the two countries. PPP works on the principal of law of one price i,e the price of goods in one country will be equal to the price of same goods in other country's currency.

Let us assume steel price in US are $50 per tonne , then the same steel must exactly cost $50 equivalent in Japanese Yen. Let us also assume that same steel costs Yen 6000 per tonne in Japan.

Further the price to be equal the current spot exchange rate between the Dollar and Yen should be =

cost of steel in Japanese Yen / cost of steel in Dollar

6000 / 50 = Yen 120 per Dollar.

If there is any change in price of steel in any country the exchange rate between Dollar and Yen will change proportionately to reflect one price and thus not affecting the firm or the country.

Let us assume price to steel in US rose to $55 per tonne (due to inflation of 10%)

and price of steel in Japan rose to Yen 6300 per tonne (due to inflation of 5%)

As inflation is more in US therefore Japanese Yen has to appreciate to prevail law of one price

New Exchange rate will be 120 * 1.05/1.1 = 114.54

Thus as per new exchange rate

$ 55 * 114.54 = Yen 6300 The price of steel is same in both Dollar and Yen.