Chapter 9

Taking a Bite Out of the Purchasing Power Parity (PPP)

In This Chapter

arrow Understanding the relationship between the PPP and the MBOP

arrow Exploring the relationship between inflation differentials and changes in exchange rates

arrow Deriving the PPP

arrow Estimating the PPP-suggested future spot rate

arrow Understanding the Big Mac standard

The models of exchange rate determination in Chapters 5, 6, and 7 predict the direction of change in the exchange rate in terms of appreciation or depreciation. This chapter aims to attach a number to the direction of change in the exchange rate. In other words, using the purchasing power parity (PPP), you can predict that, for example, the dollar will depreciate by 2 percent.

Whereas the interest rate parity (IRP; see Chapter 8) looks at the interest rate differential between two countries, the PPP considers the inflation rate differential to predict changes in the exchange rates. Therefore, as in the case of the IRP, the PPP also provides a “best guess” regarding ...

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