Question

1. Explain the concept of PPP theorem. How does it influence long term exchange rates?

2. Numerical problems about undervaluation/overvaluation of currencies; application of PPP theorem.

3. If U.S. visitors to Mexico can buy more goods in Mexico than they can in the U.S. when they convert their dollars to pesos, is the dollar undervalued or overvalued? Explain.

Answer 1

ans....

In very simple terms, the defination of PPP is a theory which states that exchange rates between currencies are in equilibrium when the purchasing power is same in each of the two countries. It is said that in the long run, a basket of goods should ideally cost the same irrespective of in which country you live, taking into account their exchange rate.

Lets understand this with the help of an example. But before that just keep in mind whenever we say that 'taking into account their exchange rate', we mean that only exchange rate differential would be there and nothing else, and by that we mean, the strength of purchasing power of $1 is Rs.50 and not Rs.1 (assuming exchange rate $1=Rs.50).

Lets assume that the current exchange rate is $1=50 INR (Indian rupees). In U.S a cricket bat is sold for $40, while in India it is sold for Rs750 (ceteris paribus). Since $1=50 INR, so that bat will cost 750/50 = $15 in U.S and people from U.S would start importing the bat from India because it is now cheaper than buying from U.S. The consequences would be : the demand for bat in India would increase - with this the price of bat in India would also start rising - also since India is exporting so there'll be more demand for Indian currency and hence the currency would appreciate. Lets say now the price of bat in India is 1200 INR.

Consequences in U.S - demand for bat has fallen - price would also start falling - since U.S is importing the bat so the currency would depreciate against INR. Let the price in U.S has fallen to $30 and the exchange rate is now, $1=40 INR (where the INR has appreciated and $ has depreiciated).

Bat in India is for 1200INR, that is, 1200/40 = $30, which costs the same in U.S now, hence U.S will no longer better off importing the bat from India. The price differentials between countriesare not sustainable in long run as the market forces will equalise prices. We say that there is equilibrium established and purchasing power parity has reached.

If the U.S visitors to Mexico can buy more goods when they convert their currencies, we say the dollar was overvalued an the pesos are undervalued. Understand it this way, suppose the exchange rate is $1=60P (P=pesos), this means that with $1, you can buy goods worth 60 pesos in Mexico. Now when the exchange rate

revises to $1=70P where the $ has appreciated and pesos have depriciated, with $1 the tourist can now buy goods worth 70 pesos. So when a tourist can buy more of a good in when in foreign land than in their home land we say the home currency is overvalued and the currency of other country is undervalued. Now for a Mexican tourist, the things would be other way round on his trip to U.S, everything would be expensive as compared to his homeland.