Question

1. Explain Purchasing Power Parity.

2. Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only 2%. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble?

3. In order for the condition E$/HK$ = PUS/PHK to hold, what assumptions does the principle of purchasing power parity make? Please note HK means Hong Kong.

Answer 1

1. Answer:

Definition: The theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other. In other words, the expenditure on a similar commodity must be same in both currencies when accounted for exchange rate. The purchasing power of each currency is determined in the process.

Description: Purchasing power parity is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country.

Calculating Purchasing Power Parity

The relative version of PPP is calculated with the following formula:

where:

S= Exchange rate of currency 1 to currency 2

P1​= Cost of good X in currency 1

P2​= Cost of good X in currency 2

Drawbacks of Purchasing Power Parity:

          Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac hamburger across many countries. Their study results in the famed "Big Mac Index". In "Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.

• Transport Costs
• Tax Differences
• Government Intervention
• Non-Traded Services
• Market Competition

2. Answer:

The Russian ruble should depreciate against Swiss franc by 198 percent.

3. Answer:

HK and US are perfectly competitive and there are no transportation costs or restrictions on trade.