The International Finance

INTERNATIONAL FINANCE

International Finance
2. Purchasing Power Parity (PPP)
There is a relation between level of price and the exchange rate which is determined by the
famous theory named Purchasing Power Parity (OECD, n.d.). It is often abbreviated as
PPP. There are two versions of theory of purchasing power parity:
1. The Absolute PPP.
2. The Relative PPP.
2.1. Absolute PPP
Absolute Purchasing Power Parity is a theory that works with the same logic as that of
Law of One Price or in other words, the price at which the goods are sold in different
markets are same after providing the adjustment for rate of exchange or exchange rate. It is
a pure theory of price-level which considers the same basket of goods in every country
ignoring any other factors. According to this concept, the currency’s exchange-rate would
gradually change over a period of time until the goods hold an equal value because without
any trade barriers there should be equilibrium in the goods’ prices (IG, n.d.).
As per Absolute PPP, rate of exchange between the currencies of two different nations is
always equal to the ratio of levels of price of basket of goods.
where,
two nations are, (AUD/USD)
foreign price level is, (USA).
Therefore,
1
Domestic Price Level (P) = [Exchange rate between two
nations (S)] x [Foreign (USA) Price Level (P*)]
S=P/P*

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2.1.1 Methodology
The ratio of Australia and USA prices are considered for computing the implied Purchase
Power Parity exchange rate. The issue is that the price level given by CPI for Australia and
USA is dependent on different base years. Hence, there arises a requirement to base both
nations’ CPI to the same time-period. Since, our analysis is based upon a ten years period,
the selected base-period for our analysis is March 2010. Therefore, implied Purchase
Power Parity spot rate is computed using the below formula:
where,
P0 = CPI of Australia in Mar-2010.
P*o = CPI of USA in Mar-2010.
Plotting the ratio of CPI of USA and Australia based upon Mar-2010 against the
AUD/USD actual spot exchange rate gives the following the graph:
Figure - 2.1.1
2
St/So=(Pt/Po)/(P*t/P*o)

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Figure - 2.1.2
The above Figure (2.1.1) represents the existing relation between the exchange rate
implied by Purchasing Power Parity and the actual spot exchange rate of AUD/USD spot
rate over ten years’ time-period. The above figure depicts that the rate implied by
Purchasing Power Parity has mere fluctuations, but throughout the observed period the
market spot rate has been highly volatile. This volatility can also be seen in the Figure
2.1.2, that shows deviation of the market spot rate from the exchange rate implied by
Purchasing Power Parity in this time-period. From the year 2010 to year 2013 the
deviation was really small but it widens from the year 2014 and then happened a
significant deviation between the year 2015 and year 2019. Therefore, on the basis of this
observation it can be inferred that the theory of absolute Purchasing Power Parity fails to
explain the AUD/USD market spot rate fluctuations in the observed time-period. .
2.2. Relative PPP
There is always a difference between the inflation rates of two different nations and these
differences are considered by the Relative PPP theory. It means, the relative rate of change
existing between foreign price-level & domestic price-level would depict the rate at which
exchange rates will change (Nasdaq, n.d.).
3
∆S=∆P- ∆P*