PPP Exchange Rates

• Purchasing power parity theory

  Economists say the exchange rate between two currencies should reflect the relative purchasing power of those currencies - i.e. the same basket of goods and services should cost the same amount when converted between the currencies
• Nominal exchange rate


  The actual market exchange rate between two currencies
• Nominal exchange rate of 1 pound = $1.60


  Reflects purchasing power parity between UK and US
• US basket of goods increases to $1700


  Nominal exchange rate of 1 pound = $1.60 no longer reflects purchasing power parity
• Real exchange rate


  The exchange rate that takes into account changes in costs and prices to measure purchasing power parity
• Real exchange rate should be 1 pound = $1.70 to reflect purchasing power parity
• How nominal exchange rates adjust to reflect purchasing power parity

  1. Increased demand for pound as US consumers buy more UK goods

  2. Increased supply of dollars as more are sold to buy UK goods

  3. Pound appreciates, dollar depreciates to 1 pound = $1.70
• In reality, speculation dominates exchange rate movements, not trade effects
• Big Mac index


  An index that compares the price of a Big Mac in different countries to assess whether currencies are over or undervalued relative to purchasing power parity