Purchasing power parity: theory and applications

International Finance

Purchasing Power Parity

Purchasing Power Parity (PPP), also known as the law of one price, operates under the assumption that product prices in one country translate into an equal price in another country. The price similarity assumption is used to gauge currency exchange rate pressures. If the law of one price is assumed, then the premise establishes that the relational value of currencies must converge to equilibrium. The equation expresses that any inequality creates an arbitrage opportunity until equilibrium returns.

At best, the PPP is a rudimentary tool for long-term pricing pressures, however the simplicity of the equation is part of its shortcoming. Annual price level comparisons by The Economist illustrate that even the most uniform of products, for example the McDonald's Big Mac, provides little proof for the reliability of the PPP. Comparing the 2010 to 2012 Big Mac Index illustrates that none of the countries compared demonstrated price parity to the U.S. average cost, or consistent convergence towards parity.[footnoteRef:1][footnoteRef:2][footnoteRef:3] The St. Louis Federal Reserves notes that, "Clearly, absolute PPP does not hold strictly for the currencies of countries reported," and the Big Mac Index illustrates that it is too simplistic of a tool for products that embody a multitude of underlying variables.[footnoteRef:4] [1: (The Economist, 2010)] [2: (The Economist, 2011)] [3: (The Economist, 2012)] [4: (Pakko & Pollard, 2003)]

International Fisher Hypothesis

The International Fisher Hypothesis is, "The Fisher effect predicts that the real interest rate is not affected by the changes in the expected inflation rate because it results in equal changes in the nominal interest rate."[footnoteRef:5] The equation is the basis for which comparison amongst various countries can be combined with interest rate parity measures for forecasting markets. If there are no limits to the mobility of capital, then theoretically arbitrage opportunities move into equilibrium through interest rate movements. [5: (Abdulnasser, 2009)]

Evidence of the International Fisher Hypothesis is noted as reliable and that, "markets may still be considered as efficient," regardless of some disparities attributable to "transaction costs" and "exchange rate risk premium."[footnoteRef:6] [6: (Abdulnasser, 2009)]

Interest Rate Parity

Interest rate parity is the view that across countries the risk free rate of government bonds, coupled with inflation, ultimately are equal and no arbitrage opportunity exists. Divergence from interest rate parity implies the opportunity for arbitrage profits.