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S P Is The Percentage Change in The Price Levels in The United States, and P P P

The document defines the relative form of Purchasing Power Parity (PPP) using equations. PPP in its relative form states that the percentage change in the spot exchange rate (S) over a year should equal the difference between the percentage changes in price levels in the US (PUS) and UK (PUK). This can be expressed as an equation where the change in the exchange rate (S) equals the US inflation rate (PUS) minus the UK inflation rate (PUK), divided by 1 plus the UK inflation rate. An example is provided where if US inflation is 5% and UK inflation is 10%, then the dollar price of pounds should fall by 4.5% according to the relative PPP condition

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Jaydeep Mukherjee
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50 views2 pages

S P Is The Percentage Change in The Price Levels in The United States, and P P P

The document defines the relative form of Purchasing Power Parity (PPP) using equations. PPP in its relative form states that the percentage change in the spot exchange rate (S) over a year should equal the difference between the percentage changes in price levels in the US (PUS) and UK (PUK). This can be expressed as an equation where the change in the exchange rate (S) equals the US inflation rate (PUS) minus the UK inflation rate (PUK), divided by 1 plus the UK inflation rate. An example is provided where if US inflation is 5% and UK inflation is 10%, then the dollar price of pounds should fall by 4.5% according to the relative PPP condition

Uploaded by

Jaydeep Mukherjee
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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THE RELATIVE FORM OF PPP

In order to state PPP in its relative form let us define the following:
S $/£  is the percentage change in the spot exchange rate over a year,
PUS is the percentage change in the price levels in the United States, and
P is the percentage change in the price levels in Britain over a year.
UK

That is, PUS and PUK are the U.S. and British annual rates of inflation.

If the PPP condition holds in its absolute form at some moment in time, that is,
PUS = S ($/₤) PUK (1)
then at the end of 1 year, for PPP to continue to hold it is necessary that
PUS(1+ PUS ) = S ($/₤) [ 1+ S $/£  ] PUK (1+ PUK ) (2)

The left-hand side of equation (2) is the price level in the United States after 1 year, written as
the price level in the United States at the beginning of the year, multiplied by 1 plus the U.S.
annual rate of inflation. Similarly, the right-hand side of equation (2) shows the spot exchange
rate at the end of 1 year as the rate at the beginning of the year multiplied by 1 plus the rate of
change in the spot exchange rate. This is multiplied by the price level in Britain after 1 year,
written as the price level at the beginning of the year multiplied by 1 plus the British annual rate
of inflation.

Taking the ratio of equation (2) to equation (1) gives by cancellation


(1+ PUS ) = [ 1+ S $/£  ]. (l + PUK ) (3)

Equation (3) can be rearranged into


1  P us
1 + S $/£  ==
1  P uk

1  P us
or S $/£  = -1 (4)
1  P uk

Alternatively, equation (4) can be written as


P us  P uk
S $/£  = (5)
1  P uk
Equation (5) is the PPP condition in its relative, or dynamic, form.

To take an example, if U.S. inflation is 5 percent ( PUS == 0.05) and British inflation is 10 percent
( P =0.10), then the dollar price of pounds should fall—that is, the pound should depreciate—at
UK

a rate of 4.5 percent, because

P us  P uk 0.05  0.10
S $/£  = = = - 0.045, i.e., - 4.5%
1  P uk 1.10

If the reverse conditions hold, with the United States having 10 percent inflation versus 5 percent
in Britain, then S $/£  is positive, and the pound appreciates in value against the dollar by 4.8
percent;
0.10  0.05
S $/£  = = 0.48 or 4.8%
1.05
Both values are close to the 5 percent obtained from taking an approximation of equation (5) and
writing instead
S $/£   PUS - PUK (6)

What the PPP condition in this approximate form says is that the rate of change in the exchange
rate is equal to the difference between the inflation rates.

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