Purchasing Power Parity (P PP)
Purchasing Power Parity (P PP)
Purchasing Power Parity (P PP)
Parity(PPP)
Absolute Form of PPP :The absolute form of
PPP is based on the idea that, in the absence
of international barriers, consumers will shift
their demand to wherever prices are lowest.
The implication is that prices of the same
basket of products in two different countries
should be equal when measured in a
common currency.
If there is a discrepancy in the prices as
measured by such a common currency, then
demand should shift so that these prices
converge.
EXAMPLE If the same basket of products is
produced by the United States and the
United Kingdom and if the price in the
United Kingdom is lower when measured in
a common currency, then the demand for
that basket should increase in the United
Kingdom and decline in the United States.
Both forces would eventually cause the
prices of the baskets to match when
measured in a common currency. l The
existence of transportation costs, tariffs,
and quotas renders the ab
Relative Form of PPP The relative form of PPP
accounts for such market imperfections as
transportation costs, tariffs, and quotas.
This version acknowledges that these
imperfections make it unlikely for prices of the
same basket of products in different countries to
be the same when measured in a common
currency.
However, this form of PPP suggests that the rate
of change in the prices of those baskets should
be comparable when measured in a common
currency (assuming that transportation costs
and trade barriers are unchanged).
Assume that the United States and the United Kingdom trade
extensively with each other and initially have zero inflation.
Now suppose that the United States experiences a 9 percent
inflation rate while the United Kingdom experiences a 5
percent inflation rate. Under these conditions, PPP theory
suggests that the British pound should appreciate by
approximately 4 percent (the difference between their
inflation rates).
Given British inflation of 5 percent and the pound’s
appreciation of 4 percent, U.S. consumers will have to pay
about 9 percent more for British products than they paid in
the initial equilibrium state. That value is equal to the 9
percent increase in prices of U.S. products due to U.S.
inflation.
The exchange rate should adjust to offset the differential in
the two countries’ inflation rates, in which case the prices of
products in the two countries should appear similar to c
The relative PPP theory is based on the
notion that exchange rate adjustment is
necessary for the relative purchasing
power to be the same whether buying
products locally or from another country.
If that purchasing power is not equal,
then consumers will shift purchases to
wherever products are cheaper until
purchasing power equalizes.
Reconsider the previous example but now suppose that
the pound appreciated by only 1 percent in response to
the inflation differential. In this case, the increased price
of British products to U.S. consumers will be
approximately 6 percent (5 percent inflation and 1
percent appreciation in the British pound), which is less
than the 9 percent increase in the price of U.S. products
to U.S. consumers.
We should therefore expect U.S. consumers to continue
shifting their consumption to British products. Purchasing
power parity suggests that this increased U.S.
consumption of British products by U.S. consumers would
persist until the pound appreciated by about 4 percent.
Thus, from the U.S. consumer’s viewpoint, any level of
appreciation lower than this would result in lower British
prices than U.S. prices.
From the British consumer’s viewpoint, the price
of U.S. products would have initially increased by
4 percent more than British products.
Thus British consumers would continue to reduce
their imports from the United States until the
pound appreciated enough to make U.S. products
no more expensive than British products.
The net effect of the pound appreciating by 4
percent is that the prices of U.S. products would
increase by approximately 5 percent to British
consumers (9 percent inflation minus the 4
percent savings to British consumers due to the
pound’s 4 percent appreciation). l
Assume that the price indexes of the
home country (h) and a foreign country
(f ) are equal. Now assume that, over
time, the home country experiences an
inflation rate of Ih while the foreign
country experiences an inflation rate of If.
Because of this inflation, the price index
of products in the consumer’s home
country (Ph) becomes Ph ð1 þ IhÞ The
price index of the foreign country (Pf) will
also change in response to inflation in
that country.
PPP
Pfð1 þ IfÞ
Front Office
Back Office
Mid Office
Activity of Front Office
Box 1: Activities of Treasury Front Office
Statutory management
Forming market views through fundamental and technical
analysis
To manage investment by participating in money market and
forex market
Preparing daily exchange rate sheet and quotation
Maintenance of daily dealing blotter
Participate in the inter-bank market to buy and sell foreign
currency
Manage currency composition
Deal slip preparation
Helping the back office for any unreconciled entry due to any
discrepancy
Propose interest rate matrix and various investment options to
the ALCO
Center for market and risk management activity
Source: Survey Result
Activity of Back Office
Box 2: Activities of Treasury Back Office
Preparation of daily position and reconciliation with front office
Recording deals and Deal slip verification
Processing and sending deal confirmation
Receiving deal confirmation from counterparties and checking
Preparation, checking and passing of vouchers
Ensuring accounting entries
Management and Reconciliation of NOSTRO funds
Revaluation of exchange position
Justification of rate reasonability for all deals done
Managing discrepancies and disputes
Settlements
Statutory report to Bangladesh Bank
Monitoring approved exposure and position limits
Head of Back Office reports to the Managing Director on daily
basis showing details of the deals
Asset-Liability Management
Risk Management
Transfer Pricing
Derivative Products
Forex Market
Risk Exposure in Banking
Foreign Exchange Risk
Market Risk
Interest Rate Risk
Transaction Risk
Credit Risk
Portfolio Concentration
Bank Risk
Risks
Funding Liquidity Risk
Liquidity Risk
Trading Liquidity Risk
Operational Risk
Limited Products
Weak Forecasting