Interactive modelTrade & Open Economyintermediate

Purchasing Power Parity

The law of one price across borders. Big Mac index logic and long-run exchange rates.

Equilibrium: P* = 40.0, e* = 40.0

Current equations

e = P/P*: e = 1·PP now: P = 40

The same basket of goods should cost the same everywhere once you convert currencies, if it didn't, you could buy cheap and sell dear. So countries that inflate faster see their currencies fall to compensate.

Shift the curves

Domestic price level (P)0

Inflate at home and the currency depreciates one-for-one in the long run.

Foreign price level (P*)0

Foreign inflation flattens the line, your currency buys more of theirs.

The Purchasing Power Parity model, in writing

Definition

Purchasing power parity: in the long run, exchange rates move to equalize the price of the same basket of goods across countries, so currencies of high-inflation countries depreciate.

S = P_home / P_foreign ; %ΔS ≈ π_home − π_foreign

The intuition

If a basket costs twice as much in Australia as in the US at the current exchange rate, there is profit in buying American and selling Australian, and that arbitrage pressure pushes the exchange rate toward parity. It works well over decades and for big inflation gaps (the Big Mac index is the famous demo), poorly month to month, because much of what we buy is not tradeable.

Exam tip

Use the relative form for questions: the currency of the country with HIGHER inflation depreciates by roughly the inflation differential. Cite non-tradeables as the main reason PPP fails short-run.

Related models in Trade & Open Economy

Gravity Model of Trade →Interest Rate Parity →