What is Purchasing Power Parity?

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when
their purchasing power is the same in each of the two countries. This means that the exchange rate between two
countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a
country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must
depreciated in order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive
markets will equalize the price of an identical good in two countries when the prices are expressed in the same
currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US
Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV
in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process
(called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again
the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers
to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and
services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses,
and many services that are local, are of course not traded between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described
in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate
between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in
the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1
USD. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get
stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of
appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For
example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate
against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation
differences are large.

IRP
Interest Rate Parity (IRP)
Interest rate parity is one of the methods developed to explain exchange rate movements. Interest rate parity
condition states that foreign exchange markets are in equilibrium when expected returns on deposits in a given
period in one currency are equal to the expected returns on deposits in another currency when both the returns
are measured in terms of a common currency. There is a simple rule that helps us compare rates of return on
different currency deposits. To do that, an investor needs to know two pieces of information: first, the rate of
return offered by each currency deposit and second, the expected return due to one currency appreciating
against the other currency.
These two components can be combined and formulated as follows:

Here:
RA = Rate of return on currency a deposits in country A

RB = Rate of return on currency b deposits in country B

E

a/b =Expected

a/b =a/b

exchange rate of a/b one year from now.

spot rate

In summary, as a result of actions of individuals who try to maximize their returns in foreign exchange markets,
exchange rates will adjust to satisfy interest rate parity. This statement is based on the inherit assumption we are
making that is individuals in any part of the world prefer to invest in assets paying higher expected returns. It
implies that potential holders of foreign deposits view them all as equally desirable assets (in terms of similar risk
and liquidity). Therefore, should any arbitrage opportunities arise investors would take advantage driving the
difference among expected returns on deposits of different currencies to zero. Spot rates adjust as a result of
actions of arbitrageurs in the following way: since everybody would prefer dollar deposits, euro deposit holders
would try to sell euro deposits for dollar deposits. Expecting better returns, dollar deposit holders would reject
these offers. In response, euro deposit holders would try to tempt dollar deposit holders by offering better price
for dollars. This would cause the dollar to appreciate against the euro.

Interest rate parity has to do with the idea that money should (after adjusting for risk)
earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar
deposit in a United States bank, or can earn 4% interest with a British pound deposit in
a London bank. The investor can earn greater interest income by keeping funds in
dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks.
However, exchange rate expectations also come into play. Suppose the investor expects
the British pound to appreciate at the rate of 2% in terms of the dollar. That investor
would then be indifferent to either investment choice, as both are expected to earn 6%.

Question 3
The capital account and current accounts are believed to be the two elements or components of
balance of payments. Now, what is the balance of payments? It is nothing but database/recorded
information of monetary transactions between a country with other countries. These two concepts
can help students of economics understand the economic conditions of nations and write research
reports based on their observations. Since both these type of accounts are related to the balance
of payments, let us know this concept first before we understand current accounts vs. capital
accounts in the macroeconomic context.
Balance of Payments
Balance of payments is a sheet which consists of records of financial dealings between a country
and other nations. Every nation has to make some imports from other countries to satisfy its
domestic need and make some exports to earn foreign exchange. Both these import and export
details are entered into the balance of payments sheet in such a way that there is no surplus or
deficit in trade. So, the amount of goods imported should be equal to the amount of goods
exported by the country. If this does not happen and in case the import are more than the
exports, then the deficit is balanced by reducing reserves and getting loans from other nations. In
this way, the current account deficit and capital account deficit are dealt with by economic policy
makers.

Current Account
A current account is a sum of three things - net factor income, balance of trade and net transfer
payments. Net factor income is nothing but the income which comes from the sources like interest
and dividends. On the other hand, the balance of trade denotes the difference in the exports of a
country and its imports. Net transfer of payments could be related to the foreign aid which is
received by many nations. A current account, in simple words is a sign of the net income of a
nation. A surplus shows that the country's net foreign assets have risen over a fixed period while a
deficit is an indicator of decreased net foreign assets of the country. Current accounts are known
as the balance of international dealings of currently produced goods and services. Its deficits are
possible in times when exports are less than the imports. At this time, these deficits can be
balanced with the surplus on capital accounts. Merchandise trade, service such as tourism, labor,
transportation, engineering, management consulting, software services, income receipts and
unilateral transfers which are one way transfer of assets are all included in current accounts.
Capital Account
Capital account has been defined by economists as the net balance of the international investment
transactions. With such an account, we can understand the flow of money in and out of the nation.
Any surplus is an indicator of money coming inside a country while deficit reveals that money is
going out of the country. Calculation of capital account can be done by the summation of foreign
direct investment (FDI), portfolio investments, reserve account and other investments. While FDI
is the long-term capital investment with a lot of money, portfolio investments are the acquiring of
shares and bonds. The reserve account is a source of capital flows and are managed by central
bank of the nation and the other investments basically include capital flows in banks and capital
flows advanced as loans.
The International Monetary Fund (IMF) has split capital account into two sub-divisions - financial
account and capital account. The financial account involves investments and instruments like the
USA owned assets in foreign countries and foreign-owned assets in the USA. Having capital
account convertibility helps nations convert local assets into foreign assets and vice versa. The
rate of exchange will be based on the current market rats at that point of time.
Like capital account convertibility, current account convertibility can be beneficial as it allows
conversion of currency. Finally, we conclude that for ensuring rapid economic progress of a nation,
many reforms must be introduced to improve the current state of financial system.
Read more at Buzzle: http://www.buzzle.com/articles/current-account-vs-capital-account.html

Balance of Payments, from the Concise Encyclopedia of Economics

The balance of payments accounts of a country record the payments and receipts
of the residents of the country in their transactions with residents of other
countries. If all transactions are included, the payments and receipts of each
country are, and must be, equal. Any apparent inequality simply leaves one
country acquiring assets in the others. For example, if Americans buy
automobiles from Japan, and have no other transactions with Japan, the
Japanese must end up holding dollars, which they may hold in the form of bank
deposits in the United States or in some other U.S. investment. The payments of
Americans to Japan for automobiles are balanced by the payments of Japanese to
U.S. individuals and institutions, including banks, for the acquisition of dollar
assets. Put another way, Japan sold the United States automobiles, and the

United States sold Japan dollars or dollar-denominated assets such as Treasury

bills and New York office buildings....
Although the totals of payments and receipts are necessarily equal, there will be
inequalitiesexcesses of payments or receipts, calleddeficits or surplusesin
particular kinds of transactions. Thus, there can be a deficit or surplus in any of
the following: merchandise trade (goods), services trade, foreign investment
income, unilateral transfers (foreign aid), private investment, the flow of gold and
money between central banks and treasuries, or any combination of these or
other international transactions.
Imports, from AmosWEB's Economics Gloss*arama.
IMPORTS: Goods and services produced by the foreign sector and purchased by
the domestic economy. In other words, imports are goods purchased from other
countries. The United States, for example, buys a lot of the stuff produced within
the boundaries of other countries, including bananas, coffee, cars, chocolate,
computers, and, well, a lot of other products. Imports, together with exports, are
the essence of foreign trade--goods and services that are traded among the
citizens of different nations. Imports and exports are frequently combined into a
single term, net exports (exports minus imports)....
Exports, from AmosWEB's Economics Gloss*arama.
EXPORTS: The sale of goods to a foreign country. The United States, for example,
sells a lot of the stuff produced within our boundaries to other countries, including
wheat, beef, cars, furniture, and, well, almost every variety of product you care
to name. In general, domestic producers (and their workers) are elated with the
prospect of selling their goods to foreign countries--leading to more buyers, a
higher price, and more profit. The higher price, however, is bad for domestic
consumers. In that domestic consumers tend to have far less political clout than
producers, very few criticisms of exports can be heard....
Balance of Trade, from AmosWEB's Economics Gloss*arama.
BALANCE OF TRADE: The difference between the value of goods and services
exported out of a country and the value of goods and services imported into the
country. The balance of trade is the official term for net exports that makes up
the balance of payments. The balance of trade can be a "favorable" surplus
(exports exceed imports) or an "unfavorable" deficit (imports exceed exports).
The official balance of trade is separated into the balance of merchandise trade
for tangible goods and the balance of services....
A balance of trade surplus is most favorable to domestic producers responsible for
the exports. However, this is also likely to be unfavorable to domestic consumers
of the exports who pay higher prices.
Alternatively, a balance of trade deficit is most unfavorable to domestic producers

in competition with the imports, but it can also be favorable to domestic

consumers of the exports who pay lower prices....