Question

Short Answer

Can purchasing-power parity be used to explain the fact that the Canadian dollar depreciated by more than 50 percent against the German mark from 1970 to 2001, but appreciated by more than 100 percent against the Italian lira during the same period? Defend your answer.

Answer 1

Yes, purchasing-power parity can be used to explain the fact that the Canadian dollar depreciated by more than 50 percent against the German mark from 1970 to 2001, but appreciated by more than 100 percent against the Italian lira during the same period

According to purchasing - power - parity theory change in the exchange rate over a period of time should be proportional to the relative change in price levels in the two nations over the same period.

R1 = ( ( P1 / P0 ) / ( P1* / P0* ) )*R0 ( Where R1 is exchange rate in 2001 and R0 is exchange rate in 1970, similarly P0 is price level in 1970 and P1 is price level in 2001 in Canada, price levels in foreign nation is shown with a * sign. )

The inflation rate in Canada between 1970 and 2001 was 381.09%, which translates into a total increase of $381.09. This means that 1 dollars in 1970 are equivalent to 4.81 dollars in 2001. In other words, the purchasing power of $1 in 1970 equals $4.81 in 2001. The average annual inflation rate between these periods was 5.2%.

The inflation rate in Italy between 1970 and 2001 was 1,275.71%, which translates into a total increase of €12.76. This means that 1 lira in 1970 is equivalent to 13.76 lira in 2001. In other words, the purchasing power of €1 in 1970 equals €13.76 in 2001. The average annual inflation rate between these periods was 8.82%

The inflation rate in Germany between 1970 and 2001 was 179.24%, which translates into a total increase of €1.79. This means that 1 mark in 1970 is equivalent to 2.79 mark in 2001. In other words, the purchasing power of €1 in 1970 equals €2.79 in 2001. The average annual inflation rate between these periods was 3.37%.

As we can see from above inflation rate in Canada was 5.2%, whereas in Italy it was 8.82%, and in Germany it was only 3.37%, the purchasing power of these currencies differed accordingly which led to Canadian dollar depreciating by approximately 50% against German mark whereas appreciating by 100% against Italian currency.

Therefore, we can say that yes purchasing power parity can indeed explain the appreciation and depreciation of one country's currency against another.