International-Financial-Management---Bekaert-2e---

1、Chapter8 Purchasing Power Pari ty 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 amount of goods and services that can be purchased with a given amo

2、unt of the money. We measure purchasing power by first calculating the price levelt which is a weighted average of the prices of the goods and services that people consume The weights in the price level reflect the shares of these goods and services in the consumption bundle of a typical individua1.

3、 The purchasing power of the money is then found by taking the reciprocal of the price level. The units of the price level are an amount of money per consumption bundie, and the units of purchasing power are consumption bundles per unit of money. 2. Suppose the government releases information that c

4、auses people to expect that the purchasing power of a money in the future will be less than they previously had expec ted. What will happen to the exchange rate to day? Why? Answer： Typically, when people think that the purchasing power of a money is going to decline in the future, due to higher exp

5、ected inflation, they try to sell that currency today to get into a currency that will have more stable purchasing power. This reduced demand for the currency causes that currency to weaken or depreciate immediately 3. What is the difference between a price level and a price index? Answer： The price

6、 level is a weighted average of the prices of the goods and services that people consume The price index is a ratio of a price 2012 Pearson Education, Inc. 6 Chapter 8: Purchasing Power Parity and Real Exchange Rates level at one point in time to the price level in some base year, with the ratio usu

7、ally multiplied by 100. Thus, if the price level in a given year is 30% higher than the price level in the base year, the price index would be 130. Price levels give you information about the purchasing power of a currency. Price indexes give you information about the rate of inflation between two p

8、oints in time 4. What do economists mean by the law of one price? Why might the law of one price be violated? Answer： The law of one price says that the price of a good, whe n denominated in a particular currency, is the same wherever in the world the good is being sold The law of one price relies o

9、n arbitrage in the goods market If the good is being sold in one place at a low price and is being sold in a different place at a high price, people have an incentive to arbitrage the two markets Therefore, anything that makes it difficult or costly to arbitrage in the goods market can create a devi

10、ation from the law of one price Clearly, transaction costs, such as the costs of shipping, generate deviations from the law of one price that cannot be arbitraged Tariffs and quotas on imports and exports also create deviations. If markets are not competitive and firms have some monopoly power, the

11、corporation may decide to charge different prices in different countries, but it must be able to segment the markets to prevent arbitrage If arbitrage cannot be done instantaneously, there will be a speculative element that enters the calculations and the speculator may have to be compensated for th

12、e risk of loss with an expected profit from buying in one market and selling in another market at a later point in time Finally, various goods markets are subject to a certain amount of price stickiness because of the costs of changing prices Because exchange rates are asset prices and freely flexib

13、le, unanticipated changes in exchange rates will create deviations from the law of one price if goods prices are sticky. 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 it

14、s external purchasing power The internal purchasing power is calculated by taking the reciprocal of the price level, and the external purchasing power is calculated by first exchanging the domestic money into the foreign money in the foreign 2012 Pearson Education, Inc. exchange market and then calc

15、ulating the purchasing power of that amount of foreign currency in the foreign country. Hence, the prediction of absolute PPP for the exchange rate of domestic currency per unit of foreign currency is found by equating the internal purchasing power of the domestic currency to the external purchasing

16、 power of the domestic currency： =丄？丄 P(DC) Sppp P(FC) where P(DC) is the domestic price level, P(FC) is the foreign price level, and S川 signifies the exchange rate of domestic currency per unit of foreign currency that satisfies the PPP relation. By solving for S，H，, we find P(DC) P(FC) 6. If the a

17、ctual 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 uovervaluedn and uundervaluedn refers to the relationship of the exchange rate t

18、o the PPP theory. If the actual exchange rate of euros per pound is less than the PPP prediction, the euro is overvalued and the pound is undervalued We know this is the correct answer because if the actual exchange rate were to move to the PPP prediction, the euro would have to weaken, and the poun

19、d would correspondingly have to strengthen, on the foreign exchange market The weakening of the euro would correct its overvaluation, and the strengthening of the pound would correct its undervaluation. 7. What market forces prevent absolute purchasing power parity from holding in real economies? Wh

20、ich of these represent unexploited profit opportunities? Answer： Any of the forces that create a deviation from the law of one price can also cause a deviation from PPP See the answer to question 4. In addition, even if the law of one price were satisfied for al 1 goods, if the consumption bundles i

21、n the two countries put different weights on the goods because of taste differences across countries, relative price changes would 6 Chapter 8: Purchasing Power Parity and Real Exchange Rates be reflected in deviations from PPP It is our opinion that deviations from PPP do not represent unexploited

22、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 count

23、ries One way to do such a comparison is to examine the real values of the nominal in comes, that is, to multiply each of the nominal incomes times the respective purchasing powers of the currencies (which is equivalent to dividing the nominal income by the price level) The real value of the income t

24、ells you the command over goods and services that the nominal income provides when you consume in that country. If the real incomes in countries A and B were the same, we would have nominal income in counlry A _ nominal income in country B price level in country Aprice level in country B If we multi

25、ply this expression by the price level in country A, we get 4 A price level in country A .(.门 nominal income in counlry A =：x nominal income in country B price level in counlry B In the above expression, the ratio of the price level in country A to the price level in country B is the purchasing powe

26、r parity exchange rate Hence, if we multiply the nominal income in country B by the purchasing power parity exchange rate we get a nominal income that is in the units of the currency of country A and that can be compared to the nominal income in country A. If the nominal income in country A is highe

27、r than the purchasing power exchange rate multiplied by nominal income in country B, people in country A are better off in terms of their ability to consume than those in country B. If you use convert the effectively the actual exchange rate rather than the nominal income in country B into currency

28、saying you would like to earn the income PPP exchange rate of country A, you are in country B, but you to want to consume it in country A This can create incorrect inferences about where is the best place to live Suppose currency B is overvalued relative to PPP Then, the market exchange rate of curr

29、ency A per unit of currency B, denoted S, is greater than the PPP prediction, 2012 Pearson Education, Inc. price level in counlry A price level in country B That is S S In such a situation, it can happen that nominal income in country A SPPI x nominal income in counlry B in which case we know from t

30、he above discussion that we would prefer to earn income in coun try A and consume there Yet, when we compare in comes with the actual exchange rate, we might find that the nominal income in country A Sxnominal income in country B The overvaluation of curre ncy B causes us to think that the in come i

31、n country B is preferred. But, this is only correct if we earn the income in country B but consume in country A after converting our income into the currency of country A. 9. What is relative PPP, and why does it represent a weaker relationship between exchange rates and prices than absolute PPP? An

32、swer： 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 rate from absolute PPP unchanged Intuitivelyt inflation is the rate of loss of the internal purchasing power of a currenc

33、y Thus, if two currencies are losing internal purchasing power at different rates because the rates of inflation in the two countries are not equal, the rate of cha nge of the exchange rate can offset the differential rates of inflation to leave the same absolute relationship between the internal an

34、d external purchasing powers of the currencies The relative PPP theory is weaker than absolute PPP because relative PPP could be satisfied even though there are deviations from absolute PPP The requirement for relative PPP to hold is that the deviations from absolute PPP do not change over time 10.

35、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

36、 levels： RS(t,$/)= S(t,$/) x P(t,) P(O) 6 Chapter 8: Purchasing Power Parity and Real Exchange Rates Notice that the real exchange rate would be 1 if absolute purchasing power parity held because the nominal exchange rate, S(t,$/), would equal the ratio of the two price levels, P(t,$)/P(t,). Similar

37、ly, if absolute PPP is violated, the real exchange rate is not equal to 1 Thus, fluctuations in the deviations from absolute PPP are fluctuations in the real exchange rate 11. If the nominal exchange rate between the Mexican peso and the U.S. dollar is fixed, and there is higher inflation in Mexico

38、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 in the

39、 rate of inflation in the United States, the peso is appreciating in real terms and the dollar is experiencing a real depreciation. The logic is that the rate of inflation in Mexico measures the loss of internal purchasing power, while because the exchange rate is pegged, the loss of the peso s exte

40、rnal purchasing power is measured by the U. S rate of inf lat ion. If a currency s loss of internal purchasing power is greater than its loss of external purchasing power, that currency experiences a real appreciation. The real appreciation of the peso tends to make Mexican residents think that U.S.

41、 goods are relative bargains, while the real depreciation of the dollar relative to the peso, makes U.S. residents think that Mexican goods are relatively expensive Thus, the balance of trade between Mexico and the United States on the Mexican balance of payments should deteriorate with an increase

42、in imports from the United States and a decrease in exports to the United States 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? 2012 Pearson Educ

43、ation, Inc. Answer： Price indexes are ratios of the price level in a given year to the price level in a base year Because the base year is the same in the two price in dexes un der con si derat i on, we can take the ratio of the two price indexes and find the rate of inflation over that year The rat

44、io is 365/350 =1. 0429 or an inflation rate of 4. 29% 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

45、 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? Answer： The forward dollar price of wheat in Tokyo is the ratio of the futures price, 320 per bushel, to the forward exchange rate,

46、 102/$ This ratio is 320 per bushel / （ 102/$） = $3. 14 per bushel Since we can buy wheat for delivery in Chicago at $3 per bushel, if transaction costs of shipping wheat from Chicago to Tokyo are smaller than $0.14 per bushel, we could make an arbitrage profit Thus, the minimum magnitude of the tra

47、nsaction cost necessary to make this situation not represent an unexploited profit opportunity is $0. 14 per bushe1 3. Suppose that the price level in Canada is CAD16,600f the price level in France is EUR11,750, and the spot exchange rate is CADI. 35/EUR. a. What is the internal purchasing power of

48、the Canadian dollar? Answer： It is probably best to calculate the purchasing power of CAD10,000. If we divide this amount by the price level in Canada of CAD16,600, we find CAD10Q00 CAD 16,600 / consumption bundle =0.6024 consumption bundles b What is the internal purchasing power of the euro in Fra

49、nce? Answer： Performing a similar calculation to the one in part a. , we find EUR 10,000 EUR11,750/ consumption bundle =0.8511 consumption bundles 6 Chapter 8: Purchasing Power Parity and Real Exchange Rates c. What is the implied exchange rate of CAD/EUR that satisfies absolute PPP? Answer： The imp

50、lied PPP exchange rate equates the internal purchasing power of the CAD to its external purchasing power This implies that the PPP exchange rate is the ratio of the Canadian price level in Canadian dollars to the French price level in euros： d Is the euro overvalued or undervalued relative to the Ca

51、nadian dollar? Answer： Because the actual exchange rate of CAD1 35/EUR is less than the PPP exchange rate, the euro is undervalued on the foreign exchange market because it would have to strengthen to move from CAD1. 35/EUR to CAD1.4128/EUR. e. What amount of appreciation or depreciation of the euro

52、 would be required to return the actual exchange rate to its PPP value? Answer： The exchange rate moves from the actual value of CAD1. 35/EUR to the PPP value of CADI. 4128/EUR for a percentage change of1. 4128/1. 35 - 1 = 0.0466. This is a 466% appreciation of the euro versus the Canadian dollar 4.

53、 Suppose that the rate of inflation in Japan is 2% in 201L 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 diff

54、erential in the rates of inflation or 5% - 2% = 3%. The exact answer is found from equation (8.4) of the text, which incorporates a denominator correction, and we get Since we are concerned about the strengthening of the yen, let the yen be the foreign currency (FC). and let the euro be the domestic

55、 currency (DC) Then, the relative PPP formula states that the rate of appreciation of the yen is 2012 Pearson Education, Inc. 0.05 - 0.02 1 + 0.02 0.0294 or 2.94% 5. One of your colleagues at Deutsche Bank thinks that the dollar is severely undervalued relative to the yen. He has calculated that the

56、 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

57、to engage in speculation. While the data in the problem indicate that the dollar is 33. 33% undervalued, because that is the amount of dollar appreciation that would be required to take the actual exchange rate from 105/$ to the PPP prediction of 140/$, we know that the return to PPP will not be an

58、overnight event The empirical analysis of the issue indicates that the half-life of PPP deviations is around 5 years Thus, you might expect that the dollar will appreciate by 16.67% over the next 5 years But, uncovered interest rate parity actually suggests that the yen will appreciate in the short

59、run, because the yen interest rate is 3% less than the dollar interest rate Notice, though, that the correction back toward PPP can take place with differential rates of inflation in the two countries If Japanese rate of inflation falls below the U.S. rate of inflation, the PPP prediction will begin

60、 falling toward the actual exchange rate Finally, although the dollar is 33. 33% undervalued, there is no guarantee that the undervaluation will begin to be corrected now. It may, in fact, get worse If the undervaluation of the dollar goes to 50% over the next 2 years, you would lose 16.67% in the f