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

©2012PearsonEducation,Inc.Chapter8PurchasingPowerParityandRealExchangeRatesQUESTIONS1.Whatdoesthepurchasingpowerofamoneymean?Howcanitbemeasured?Answer:Thepurchasingpowerofamoneyisalsoknownasitsrealvalueandindicatestheamountofgoodsandservicesthatcanbepurchasedwithagivenamountofthemoney.Wemeasurepurchasingpowerbyfirstcalculatingthepricelevel,whichisaweightedaverageofthepricesofthegoodsandservicesthatpeopleconsume.Theweightsinthepricelevelreflectthesharesofthesegoodsandservicesintheconsumptionbundleofatypicalindividual.Thepurchasingpowerofthemoneyisthenfoundbytakingthereciprocalofthepricelevel.Theunitsofthepricelevelareanamountofmoneyperconsumptionbundle,andtheunitsofpurchasingpowerareconsumptionbundlesperunitofmoney.2.Supposethegovernmentreleasesinformationthatcausespeopletoexpectthatthepurchasingpowerofamoneyinthefuturewillbelessthantheypreviouslyhadexpected.Whatwillhappentotheexchangeratetoday?Why?Answer:Typically,whenpeoplethinkthatthepurchasingpowerofamoneyisgoingtodeclineinthefuture,duetohigherexpectedinflation,theytrytosellthatcurrencytodaytogetintoacurrencythatwillhavemorestablepurchasingpower.Thisreduceddemandforthecurrencycausesthatcurrencytoweakenordepreciateimmediately.3.Whatisthedifferencebetweenapricelevelandapriceindex?Answer:Thepricelevelisaweightedaverageofthepricesofthegoodsandservicesthatpeopleconsume.Thepriceindexisaratioofapricelevelatonepointintimetothepricelevelinsomebaseyear,withtheratiousuallymultipliedby100.Thus,ifthepricelevelinagivenyearis30%higherthanthepricelevelinthebaseyear,thepriceindexwouldbe130.Pricelevelsgiveyouinformationaboutthepurchasingpowerofacurrency.Priceindexesgiveyouinformationabouttherateofinflationbetweentwopointsintime.4.Whatdoeconomistsmeanbythelawofoneprice?Whymightthelawofonepricebeviolated?Chapter8:PurchasingPowerParityandRealExchangeRates©2012PearsonEducation,Inc.2Answer:Thelawofonepricesaysthatthepriceofagood,whendenominatedinaparticularcurrency,isthesamewhereverintheworldthegoodisbeingsold.Thelawofonepricereliesonarbitrageinthegoodsmarket.Ifthegoodisbeingsoldinoneplaceatalowpriceandisbeingsoldinadifferentplaceatahighprice,peoplehaveanincentivetoarbitragethetwomarkets.Therefore,anythingthatmakesitdifficultorcostlytoarbitrageinthegoodsmarketcancreateadeviationfromthelawofoneprice.Clearly,transactioncosts,suchasthecostsofshipping,generatedeviationsfromthelawofonepricethatcannotbearbitraged.Tariffsandquotasonimportsandexportsalsocreatedeviations.Ifmarketsarenotcompetitiveandfirmshavesomemonopolypower,thecorporationmaydecidetochargedifferentpricesindifferentcountries,butitmustbeabletosegmentthemarketstopreventarbitrage.Ifarbitragecannotbedoneinstantaneously,therewillbeaspeculativeelementthatentersthecalculationsandthespeculatormayhavetobecompensatedfortheriskoflosswithanexpectedprofitfrombuyinginonemarketandsellinginanothermarketatalaterpointintime.Finally,variousgoodsmarketsaresubjecttoacertainamountofpricestickinessbecauseofthecostsofchangingprices.Becauseexchangeratesareassetpricesandfreelyflexible,unanticipatedchangesinexchangerateswillcreatedeviationsfromthelawofonepriceifgoodspricesaresticky.5.WhatisthevalueoftheexchangeratethatsatisfiesabsolutePPP?Answer:Absolutepurchasingpowerparityrequiresthattheinternalpurchasingpowerofacurrencyequalsitsexternalpurchasingpower.Theinternalpurchasingpoweriscalculatedbytakingthereciprocalofthepricelevel,andtheexternalpurchasingpoweriscalculatedbyfirstexchangingthedomesticmoneyintotheforeignmoneyintheforeignexchangemarketandthencalculatingthepurchasingpowerofthatamountofforeigncurrencyintheforeigncountry.Hence,thepredictionofabsolutePPPfortheexchangerateofdomesticcurrencyperunitofforeigncurrencyisfoundbyequatingtheinternalpurchasingpowerofthedomesticcurrencytotheexternalpurchasingpowerofthedomesticcurrency:PPP111=?PDCSPFCwhereP(DC)isthedomesticpricelevel,P(FC)istheforeignpricelevel,andSPPPsignifiestheexchangerateofdomesticcurrencyperunitofforeigncurrencythatsatisfiesthePPPrelation.BysolvingforSPPP,wefindPPPPDCS=PFC6.IftheactualexchangeratefortheeurovalueoftheBritishpoundislessthantheexchangeratethatwouldsatisfyabsolutePPP,whichofthecurrenciesisovervaluedandwhichisundervalued?Why?Answer:Theterminologyof“overvalued”and“undervalued”referstotherelationshipoftheexchangeratetothePPPtheory.IftheactualexchangerateofeurosperpoundislessthanChapter8:PurchasingPowerParityandRealExchangeRates©2012PearsonEducation,Inc.3thePPPprediction,theeuroisovervaluedandthepoundisundervalued.WeknowthisisthecorrectanswerbecauseiftheactualexchangerateweretomovetothePPPprediction,theeurowouldhavetoweaken,andthepoundwouldcorrespondinglyhavetostrengthen,ontheforeignexchangemarket.Theweakeningoftheeurowouldcorrectitsovervaluation,andthestrengtheningofthepoundwouldcorrectitsundervaluation.7.Whatmarketforcespreventabsolutepurchasingpowerparityfromholdinginrealeconomies?Whichoftheserepresentunexploitedprofitopportunities?Answer:AnyoftheforcesthatcreateadeviationfromthelawofonepricecanalsocauseadeviationfromPPP.Seetheanswertoquestion4.Inaddition,even