Chapter 8
Purchasing Power Parity and Real
Exchange Rates
QUESTIONS
1. What does the purchasing power of a money mean? How can it be measured?
Answer: The purchasing power of a money is also known as its real value and indicates the
2. Suppose the government releases information that causes people to expect that the
purchasing power of a money in the future will be less than they previously had
expected. What will happen to the exchange rate today? Why?
3. What is the difference between a price level and a price index?
4. What do economists mean by the law of one price? Why might the law of one price be
violated?
Chapter 8: Purchasing Power Parity and Real Exchange Rates
2
Answer: The law of one price says that the price of a good, when denominated in a particular
currency, is the same wherever in the world the good is being sold. The law of one price
5. What is the value of the exchange rate that satisfies absolute PPP?
Answer: Absolute purchasing power parity requires that the internal purchasing power of a
currency equals its external purchasing power. The internal purchasing power is calculated
6. If the actual exchange rate for the euro value of the British pound is less than the
exchange rate that would satisfy absolute PPP, which of the currencies is overvalued
and which is undervalued? Why?
Answer: The terminology of “overvalued” and “undervalued” refers to the relationship of the
exchange rate to the PPP theory. If the actual exchange rate of euros per pound is less than
7. What market forces prevent absolute purchasing power parity from holding in real
economies? Which of these represent unexploited profit opportunities?
8. Why is it better to use a PPP exchange rate to compare incomes across countries than
an actual exchange rate?
Answer: When comparing incomes across countries, one is interested in comparing the
quality of life that occurs from earning such incomes and consuming in those countries. One
way to do such a comparison is to examine the real values of the nominal incomes, that is, to
Chapter 8: Purchasing Power Parity and Real Exchange Rates
4
9. What is relative PPP, and why does it represent a weaker relationship between
exchange rates and prices than absolute PPP?
Answer: The theory of relative PPP specifies that exchange rates adjust in response to
differences in inflation rates across countries to leave the deviation of the actual exchange
10. What is the real exchange rate, and how are fluctuations in the real exchange rate
related to deviations from absolute PPP?
Answer: The real exchange rate, say, of the dollar relative to the euro, is denoted RS(t,$/€). It
is defined to be the nominal exchange rate multiplied by the ratio of the price levels:
11. If the nominal exchange rate between the Mexican peso and the U.S. dollar is fixed, and
there is higher inflation in Mexico than in the United States, which currency
experiences a real appreciation and which experiences a real depreciation? Why? What
is likely to happen to the balance of trade between the two countries?
Answer: If the peso is pegged to the dollar and the rate of inflation in Mexico is greater than
PROBLEMS
1. If the consumer price index for the United States rises from 350 at the end of a year to
365 at the end of the next year, how much inflation was there in the United States
during that year?
2. As a wheat futures trader, you observe the following futures prices for the purchase
and sale of wheat in 3 months: $3.00 per bushel in Chicago and ¥320 per bushel in
Tokyo. Delivery on the contracts is in Chicago and Tokyo, respectively. If the 3-month
forward exchange rate is ¥102/$, what is the magnitude of the transaction cost
necessary to make this situation not represent an unexploited profit opportunity?
3. Suppose that the price level in Canada is CAD16,600, the price level in France is
EUR11,750, and the spot exchange rate is CAD1.35/EUR.
a. What is the internal purchasing power of the Canadian dollar?
b. What is the internal purchasing power of the euro in France?
c. What is the implied exchange rate of CAD/EUR that satisfies absolute PPP?
d. Is the euro overvalued or undervalued relative to the Canadian dollar?
e. What amount of appreciation or depreciation of the euro would be required to
return the actual exchange rate to its PPP value?
4. Suppose that the rate of inflation in Japan is 2% in 2011. If the rate of inflation in
Germany is 5% during 2011, by how much would the yen strengthen relative to the
euro if relative PPP is satisfied during 2011?
Answer: The approximately correct answer is that the yen should strengthen by the
5. One of your colleagues at Deutsche Bank thinks that the dollar is severely undervalued
relative to the yen. He has calculated that the PPP exchange rate is ¥140/$, whereas the
current exchange rate is ¥105/$. Because interest rates are 3% p.a. lower in Japan than
in the United States, he thinks that this is a good time to speculate by borrowing yen
and lending dollars. What do you think?
Answer: Deviations from PPP are a weak reason to engage in speculation. While the data in
the problem indicate that the dollar is 33.33% undervalued, because that is the amount of
6. Suppose that you are trying to decide between two job offers. One consulting firm
offers you $150,000 per year to work out of its New York office. A second consulting
Chapter 8: Purchasing Power Parity and Real Exchange Rates
8
firm wants you to work out of its London office and offers you £100,000 per year. The
current exchange rate is $1.65/£. Which offer should you take, and why? Assume that
the PPP exchange rate is $1.40/£ and that you are indifferent between working in the
two cities if the purchasing power of your salary is the same.
Answer: We know from the extensive discussion in Question 8 that we should use the PPP
7. Suppose that in 2011, the Japanese rate of inflation is 2%, and the German rate of
inflation is 5%. If the euro weakens relative to the yen by 10% during 2011, what would
be the magnitude of the real depreciation of the euro relative to the yen?
8. Pick a particular brand of appliance, like a Bosch dishwasher with certain features, and
use the internet to compare its prices across countries. Be sure to have exactly the same
style of appliance in each country. How different are the prices when expressed in a
common currency?
We found the Bosch Ascenta series Model SHX6AP05UC on sale at Sears-Canada for
9. Go to the IMF’s web site at www.imf.org, find the Data and Statistics tab, locate World
Economic Outlook (WEO) data, and download the “Implied PPP conversion rate” for
the Indonesian rupiah and the Philippines peso versus the dollar. Calculate a rupiah per
peso PPP rate and compare it to the actual exchange rate. Which currency is
overvalued, and by how much?
Go to the IMF’s WEO site at