International Trade

Project Assignment

Purchasing Power Parity

25 points

The idea behind purchasing power parity (PPP) is something called the law of one price. If there are different prices for the same product, people will naturally purchase only the lowest priced good. This is true locally as well as internationally. So, for example, if in the U.K. chocolate bars sell for $1.00 and in the U.S. they sell for $0.50, people in the U.K. would want to buy chocolate bars from the U.S. I am sure that you can see the inevitable complication in the above argument. The U.K. does not use U.S. dollars. It uses British pounds. So, in order to calculate the prices one has to use exchange rates. Continuing with the above example, if the Brits buy chocolate bars from the U.S., they have to buy U.S. dollars in order to make the purchase. This increases the demand for U.S. dollars and drives up the cost of those dollars (£/$). As the cost of U.S. dollars rises in terms of pounds the chocolate bars become more costly to the Brits. This process should continue until purchasing power parity is reached. [You should also read the explanation in your textbook on pages 401 to 406.]

This concept of PPP is referred to as absolute PPP and can be described mathematically this way:

In other words, as the domestic price level rises, the domestic price of foreign currency [ERdomestic/foreign] also rises.

Now, anyone who has traveled internationally is well aware that there can be dramatic price differences between identical products sold in different countries. So, there are problems with absolute PPP. Most economists believe that the adjustment process takes a very long time internationally. In fact, the adjustment process is so long that most economists don’t believe that absolute PPP is a very worthwhile predictor of exchange rate changes.

A more useful concept of PPP is expressed in relative terms and is, therefore, usually called relative PPP. In simple terms, the mathematical expression of relative PPP is:

where the ^ character represents percentage change.

In words, the percentage change in the exchange rate should reflect the difference in inflation rates in the two countries. So, if the inflation rate in the U.S. is higher than the inflation rate in the U.K. the dollar price of British pounds should increase as people in the U.S. attempt to buy the cheaper British products.

Your project is to provide a simple test of the accuracy of relative purchasing power parity. If relative purchasing power parity accurately predicts exchange rates, the following formula should hold: [This formula is based on the formula above but written more completely in a simplified form.]

Where:

In the above equation, p represents the inflation rate that must be calculated for both the United States and your assigned country. Yc represents your country and W stands for your country’s currency. The subscript t stands for the time period (year, in this case). P stands for the price level, the CPI in this case.

In order to conduct this test, you will need to acquire exchange rate data for the U.S dollar and your assigned country’s currency for the years 1970-2000 (this is $/W in the above equations). You will also need to acquire price level data for the U.S. and price level data for your country for the years 1970-2000 (i.e. the CPI for each country). Once this data is acquired it should be put into a spreadsheet with the appropriate headings. At this point you should be ready to perform the test.

[It might be possible to obtain the requisite data over the internet. However, some of the central banks that usually provide the data do not provide it for all years. So, I recommend the publications International Financial Statistics and International Financial Statistics Yearbook. They are both published by the IMF (International Monetary Fund) and, if you are not familiar with them, you should be. They provide financial and economic data for almost every country in the world. The library on the main campus of A.S.U. has the latest yearbook in its reference section. For those of you closer to Little Rock, Fayetteville or Memphis, the university libraries in those cities also keep these periodicals and yearbooks on their shelves.]

Once you have your data in spreadsheet form, you need to calculate both sides of the equation and do a comparison. If purchasing power parity works in a one year time frame, the numbers should be roughly the same. However, one of the points made by economists about relative purchasing power parity is that it may take quite some time for it to work. So, you need to calculate: five year averages, ten year averages and thirty year averages for the above numbers. Then, compare the results for the different time periods.

After you have made your calculations, you should write a brief summary of what you did. You should also explain how your calculations provide insight into the relevance of relative PPP.

I know that you will probably have questions. I will set up a thread on the forum so that you can communicate with each other about this problem. That should provide some help. Of course, you can also send me an email or give me a call.