Page 77 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes the US is twice the general price level in the UK, the absolute PPP theory postulates the
equilibrium exchange rate to be Rab = $2/£1.
In reality, the exchange rate between the dollar and the pound could vary considerably from
$2/£1 due to various factors like transportation costs, tariffs, or other trade barriers between the
two countries. This version of the absolute PPP has a number of defects. First, the existence of
transportation costs, tariffs, quotas or other obstructions to the free flow of international trade
may prevent the absolute form of PPP. The absolute form of PPP appears to calculate the exchange
rate that equilibrates trade in goods and services so that a nation experiencing capital outflows
would have a deficit in its BOP while a nation receiving capital inflows would have a surplus.
Finally, the theory does not even equilibrate trade in goods and services because of the existence
of non-traded goods and services.

Non-traded goods such as cement and bricks, for which the transportation cost is too high,
cannot enter international trade except perhaps in the border areas. Also, specialised services
like those of doctors, hairstylists, etc., do not enter international trade. International trade tends
to equate the prices of traded goods and services among nations but not the prices of non-traded
good and services. The general price level in each nation includes both traded and non-traded
goods and since the prices of non-traded goods are not equalised by international trade, the
absolute PPP will not lead to the exchange rate that equilibrates trade and has to be rejected.

5.1.2 Relative Purchasing Power Parity

The relative form of PPP theory is an alternative version which postulates that the change in the
exchange rate over a period of time should be proportional to the relative change in the price
levels in the two nations over the same time period. This form of PPP theory accounts for market
imperfections such as transportation costs, tariffs and quotas. Relative PPP theory accepts that
because of market imperfections prices of similar products in different countries will not
necessarily be the same when measured in a common currency.

Did u know? What it specifically states is that the rate of change in the prices of products
will be somewhat similar when measured in a common currency as long as the trade
barriers and transportation costs remain unchanged.
Specifically, if subscript ‘0’ refers to the base period and ‘1’ to a subsequent period then relative
PPP theory postulates that

P/P
R = i a 0 a R
ab1 ab0
P/P b0
bi
where R and R refer to the exchange rates in period 1 and in the base period respectively.
ab1 ab0
If the absolute PPP were to hold true, the relative PPP would also hold. However, the vice versa
need not hold. For example, obstructions to the free flow of international trade like transportation
costs, existence of capital flows, government intervention policies, etc. would lead to the rejection
of the absolute PPP. However, only a change in these factors would lead to the rejection of the
relative PPP.

5.1.3 Graphic Analysis of Purchasing Power Parity

Figure 5.1 shows the Purchasing Power Parity theory which helps us to assess the potential
impact of inflation on exchange rates. The vertical axis measures the percentage appreciation or
depreciation of the foreign currency relative to the home currency while the horizontal axis

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