International Finance:

Purchasing Power Parity and Real Exchange Rate

Pasquale Della Corte

Imperial College London

Lecture 3

Pasquale Della Corte (Imperial) International Finance Lecture 3 1 / 61

Last Week: A Brief Summary

Covered Interest Parity (CIP)

forward premium is equal to interest rate di¤erential

two investments bearing the same risk must have the same return

enforced by arbitrage between the spot and forward exchange rates,

and money market interest rates

Uncovered Interest parity (UIP)

expected exchange rate return is o¤set by interest rate di¤erential

high interest rate currencies are expected to depreciate in the future

driven by speculation between current and future spot exchange rates,

and money market interest rates

cornerstone condition for testing FX market e¢ ciency

Pasquale Della Corte (Imperial) International Finance Lecture 3 2 / 61

This Week: A Brief Introduction

Purchasing Power Parity (PPP)

simple model of exchange rate determination

relation between exchange rates and the prices of goods and services in
di¤erent countries

the same bundle of goods and services must have the same price
anywhere in the world

PPP provides a baseline to forecast future exchange rates

forecasting future cash ‡ows in di¤erent currencies

deciding on the international location of manufacturing plants
assessing cost-of-living in a di¤erent country

Pasquale Della Corte (Imperial) International Finance Lecture 3 3 / 61

Law of One Price
Assumptions
goods & services are homogeneous (perfect substitutes) and tradable
absence of transaction costs (taxes & shipping costs) and barriers to
trade (embargo)
commodity arbitrage as driving force

Equilibrium Condition
Pt,i = St Pt,i
Pt,i is the domestic price of an homogeneous good i
Pt,i is the foreign price of an homogeneous good i
St is the spot exchange
St Pt,i is the foreign price expressed in domestic currency

The price of identical goods must be the same across

countries when expressed in a common currency
Pasquale Della Corte (Imperial) International Finance Lecture 3 4 / 61
Commodity Arbitrage

Raul, a European-based consumer, is planning to buy a new Apple

iPod touch 8GB
while browsing US Amazon, he spots a price of $223.99

on UK Amazon, instead, he …nds a price of £ 189.00

hence, he decides to do a quick comparison of both prices in euro using

euro-dollar and euro-pound quotes from Oanda.com
1
US Amazon : $223.99 = e159.12
$1.39632/e
1
UK Amazon : £ 189.00 = e215.01
£ 0.87904/e
before shipping costs, he observes a substantial price di¤erential and....

Pasquale Della Corte (Imperial) International Finance Lecture 3 5 / 61

Dual-listed Companies

In a dual-listed company (DLC) structure

two companies agree to operate as if they were a single enterprise but
maintain separate legal identities and stock exchange listings
similar to a traditional merger but separate identities and shareholders
for tax reasons
the shares of the DLC parents represent claims on exactly the same
underlying cash ‡ows.

Royal Dutch/Shell is a well-known example

Royal Dutch (Netherlands) and Shell (UK) merged in 1907: 60%
(40%) ownership of the new Group to the Dutch (British) arm
in the early 1980s, Royal Dutch traded in Amsterdam at a signi…cant
discount relative to Shell in London
an arbitrage strategy involved a long position in Royal Dutch and a
short position in Shell after having hedged the currency risk.
Pasquale Della Corte (Imperial) International Finance Lecture 3 6 / 61
Log Deviations From Parity: Royal Dutch/Shell
Log Deviations From Parity: Royal Dutch / Shell

20%

10%
Percent Deviation

0%

-10%

-20%

-30%

-40%
01/01/1980 01/01/1983 01/01/1986 01/01/1989 01/01/1992 01/01/1995 01/01/1998 01/01/2001 01/01/2004

Source: De Jong, Rosenthal and Van Dijk (2009)

Pasquale Della Corte (Imperial) International Finance Lecture 3 7 / 61
Purchasing Power Parity

The purchasing power parity (PPP) is simply the law of one price
extended to all traded goods & services

Pt = St Pt

Pt = ∑N
i =1 wi Pt,i is the domestic price level for N goods
Pt = ∑N
i =1 wi Pt,i is the foreign price level for N goods
wi is the proportion of the good i in the domestic basket
wi is the proportion of the good i in the foreign basket
a common market basket of goods & services across countries

A unit of domestic currency must have the same

purchasing power both at home and abroad

Pasquale Della Corte (Imperial) International Finance Lecture 3 8 / 61

GDP per Capita: Current Price versus PPP

US dollars: US dollars: US dollars: US dollars:

Country Market Rate PPP Rate Country Market Rate PPP Rate

Luxembourg 104, 390 80, 304 United Kingdom 36, 298 35, 053
Singapore 42, 653 57, 238 Finland 43, 134 34, 402
Norway 84, 543 52, 239 France 40, 591 34, 092
United States 47, 132 47, 132 Japan 42, 325 33, 828
Hong Kong SAR 31, 799 45, 277 Korea 20, 165 29, 791
Switzerland 67, 074 41, 765 Spain 29, 875 29, 652
Netherlands 46, 418 40, 777 Italy 33, 829 29, 418
Australia 54, 869 39, 692 Israel 27, 085 29, 405
Austria 43, 723 39, 454 Greece 27, 265 28, 834
Canada 45, 888 39, 034 Cyprus 27, 722 28, 045
Ireland 45, 642 38, 816 Slovenia 23, 009 27, 900
Sweden 47, 667 37, 775 New Zealand 31, 589 27, 420
Denmark 55, 113 36, 764 Czech Republic 18, 722 24, 987
Iceland 39, 563 36, 681 Malta 18, 586 24, 081
Belgium 42, 597 36, 275 Portugal 21, 031 23, 114
Germany 40, 512 35, 930 Slovak Republic 15, 906 22, 267

Source: International Monetary Fund, World Economic Outlook Database, October 2010.

IMF data

Pasquale Della Corte (Imperial) International Finance Lecture 3 9 / 61

Who Contributes Most to Global Growth?

Pasquale Della Corte (Imperial) International Finance Lecture 3 10 / 61

Price Level

The price level is the weighted average of the nominal prices of the
goods & services consumed in the economy

The weights re‡ect the percentage shares of the goods & services in
the consumption bundle (∑N i =1 wi = 1). They are di¤erent because
goods are not all equally important.

If clothes constitute 10% of the typical consumer’s budget, the price

of clothes will receive a weight of 10% in the price level

When the price level of an economy is rising (falling ), in‡ation

(de‡ation) is occurring

Pasquale Della Corte (Imperial) International Finance Lecture 3 11 / 61

Price Level

Example: Price of salt doubled! Gas price also up by 10%

What is the impact of these price changes?

Unweighted Average: goods are equally important

Change in Pt = (100% + 10% + 0%) /3 ' +37%

Weighted Average: accounts for the contribution of each good to

the average household’s expenditure

Change in Pt = (0.01 100%) + (0.1 10%) + (0.89 0%) ' +2%

where wsalt = 0.01, wgas = 0.1 and wresidual basket = 0.89

Salaries should increase by 2% to consume the same bundle

Pasquale Della Corte (Imperial) International Finance Lecture 3 12 / 61

Purchasing Power Parity

Two versions of PPP

(Absolute) Purchasing Power Parity

the nominal exchange rate in equilibrium is equal to the price level ratio

link between nominal exchange rate and price levels

strong condition

Relative Purchasing Power Parity

the nominal exchange rate change in equilibrium is equal to the
in‡ation di¤erential

link between nominal exchange rate returns and in‡ation rates

weak condition

Pasquale Della Corte (Imperial) International Finance Lecture 3 13 / 61

Purchasing Power Parity
Purchasing power parity (PPP) is a theory of exchange rate
determination which re‡ects di¤erences in prices across countries
Pt
St =
Pt

Nominal exchange rate should be equal to the price level ratio

as Pt rises relative to Pt =) St should rise

domestic currency should # and foreign currency should "
as Pt rises relative to Pt =) St should fall
domestic currency should " and foreign currency should #

A rise in home price level caused by a monetary expansion should

result in an equi-proportionate depreciation of the exchange rate
Pasquale Della Corte (Imperial) International Finance Lecture 3 14 / 61
Purchasing Power Parity

Example: Market spot rate versus PPP spot rate

Actual spot rate is $2.10/£ while PPP spot rate is $1.70/£
Pt
$2.10/£ = St > = $1.70/£
Pt
GBP is overvalued in the FX market (more expensive than PPP)
PPP spot rate (= Pt /Pt ) is the equilibrium rate implied by PPP

What is the over(+)/under(-) valuation of the foreign currency?

Actual PPP St (Pt /Pt ) 2.10 1.70

= = 0.23 (23%)
PPP Pt /Pt 1.70

GBP is approximately overvalued by 23% against USD

Pasquale Della Corte (Imperial) International Finance Lecture 3 15 / 61

Purchasing Power Parity

What is the over(+)/under(-) valuation of the domestic currency?

by inverting both actual and PPP rates, we obtain

1 1 1 1
Actual PPP St P t /P t
=
1 1
PPP P t /P t

PPP Actual (Pt /Pt ) St

=
Actual St
1.70 2.10
= 0.19 ( 19%)
2.10
USD is approximately undervalued by 19% against GBP.

Pasquale Della Corte (Imperial) International Finance Lecture 3 16 / 61

PPP Rate and Market Rate: USD/GBP)

Spot > PPP (GBP overvalued)

Spot < PPP (GBP undervalued)

Pasquale Della Corte (Imperial) International Finance Lecture 3 17 / 61

PPP Rate and Market Rate: MXN/USD

Pasquale Della Corte (Imperial) International Finance Lecture 3 18 / 61

Purchasing Power Parity and Properties

Causation
a change in money supply (stock of money in the economy) a¤ects
prices and exchange rates

Homogeneity (Neutrality of Money)

nominal exchange rate and price ratio will change in a proportional
manner
adjustment in nominal prices ( wages and exchange rates) but not in
real variables (employment and units of consumption)

Symmetry
changes in domestic or foreign price levels imply equal but opposite
changes in the nominal exchange rates

Pasquale Della Corte (Imperial) International Finance Lecture 3 19 / 61

Purchasing Power Parity

PPP di¢ cult to measure

basket of goods are not standardized across countries
goods may be not perfect substitutes across countries
price weights may be di¤erent across countries
non-traded goods may be included in the basket
shipping costs and barrier tari¤s may limit commodity arbitrage
governments report price indexes rather than price levels

Barriers and frictions to international trade may limit PPP

Pasquale Della Corte (Imperial) International Finance Lecture 3 20 / 61

Relative Purchasing Power Parity

Relative PPP restates the condition in terms of changes in relative

prices levels and exchange rate changes

Let K be a constant re‡ecting some deviations from PPP

Pt = St Pt K at time t

Pt +1 = St +1 Pt +1 K at time t + 1

Consider the ratio

Pt +1 St +1 Pt +1
=
Pt St Pt

Pasquale Della Corte (Imperial) International Finance Lecture 3 21 / 61

Relative Purchasing Power Parity

Rearrange as
St + 1 Pt +1 /Pt
=
St Pt +1 /Pt
which is equivalent to
St + 1 1 + π t +1
=
St 1 + π t +1

where
P t +1 P t
π t +1 = Pt =) domestic in‡ation rate

P t +1 P t
π t +1 = Pt =) foreign in‡ation rate

Pasquale Della Corte (Imperial) International Finance Lecture 3 22 / 61

Relative Purchasing Power Parity

By subtracting 1 from both sides, we obtain

St + 1 St π t +1 π t +1
=
St 1 + π t +1

For low in‡ation countries

St + 1 St
π t +1 π t +1
St

% exchange rate change = % in‡ation di¤erential

Pasquale Della Corte (Imperial) International Finance Lecture 3 23 / 61

Relative Purchasing Power Parity

if domestic price level increases faster than foreign price level

domestic money loses more rapidly its value relative to foreign money

domestic currency depreciates and foreign currency appreciates

Pasquale Della Corte (Imperial) International Finance Lecture 3 24 / 61

Real Exchange Rate

The real exchange rate (RER) is the price of foreign goods relative
to domestic goods
P
Qt = St t
Pt
If PPP holds, the real exchange rate equals

Pt
Qt = St =1
Pt

the real exchange rate is de…ned as units of domestic goods per one
unit of foreign good

The real exchange rate is the nominal exchange

rate adjusted for the relative price levels

Pasquale Della Corte (Imperial) International Finance Lecture 3 25 / 61

Real Exchange Rate

The real exchange rate is a measure of international competitiveness

PPP holds continuously

PPP holds at any point in time

international competitiveness is not systematically a¤ected by changes

in nominal exchange rate

PPP holds on average

short-term deviations from PPP

changes in nominal exchange rate cause changes in the real exchange

rate a¤ecting the international competitiveness

Pasquale Della Corte (Imperial) International Finance Lecture 3 26 / 61

Real Exchange Rate

Pt
Qt = St
Pt
Qt = 1 =) Competitiveness of the foreign country is unaltered
Pt
St = 1 =) St Pt = Pt
Pt

Qt < 1 =) Competitiveness of the foreign country improves

Pt
St < 1 =) St Pt < Pt
Pt

Qt > 1 =) Competitiveness of the foreign country deteriorates

Pt
St > 1 =) St Pt > Pt
Pt

Pasquale Della Corte (Imperial) International Finance Lecture 3 27 / 61

Real Exchange Rate

The real exchange rate provides a measure of misalignment of the

domestic currency versus the foreign currency

Qt = 1 =) foreign currency has equal purchasing power

domestic and foreign goods are equally expensive

Qt < 1 =) foreign currency is undervalued

foreign goods are cheaper than domestic goods

Qt > 1 =) foreign currency is overvalued

foreign goods are more expensive than domestic goods

Pasquale Della Corte (Imperial) International Finance Lecture 3 28 / 61

Log Approximations

Absolute Purchasing Power Parity

Pt
ln St = ln =) st = pt pt
Pt

Relative Purchasing Power Parity

St + 1 Pt +1 /Pt
ln = ln =) st +1 st = π t + 1 π t +1
St Pt +1 /Pt

Real Exchange Rate

Pt
ln Qt = ln St =) qt = st + pt pt
Pt

st = ln St , pt = ln Pt , ln (Pt +1 /Pt ) = π t +1 , and ( ) indicates

foreign country

Pasquale Della Corte (Imperial) International Finance Lecture 3 29 / 61

Price Index

Governments generally report data on price indexes rather than on

price levels

A price index is constructed by normalizing each price level with

respect to a base year
!
Pt ∑Ni =1 wi Pt,i
It = 100 = 100
P0 ∑Ni =1 wi P0,i

Consumer Price Index (CPI) or Wholesale Price Index (WPI) are

an example
di¤erent price indexes may have a di¤erent base year

di¤erent sources may use a di¤erent base year

Pasquale Della Corte (Imperial) International Finance Lecture 3 30 / 61

Computing the PPP Spot Rate

How can we determine PPP spot rate and RER if we do not observe
price levels?

Assumption: PPP holds exactly at time τ with 0 < τ < T

0 τ T

1990 1994 2005

I0 = 100 Qτ = Sτ PPττ = 1 End of

I0 = 100 period

Pasquale Della Corte (Imperial) International Finance Lecture 3 31 / 61

Computing the PPP Spot Rate

PPP spot rate as follows

Pt P0
Pt P 0 P τ Pτ It I1τ Pτ
St = = =
Pt Pt P0
Pτ It 1
Pτ
P0 Pτ Iτ

1 1 1
= It Pτ I
Iτ It τ Pτ
It Iτ Pτ It Iτ
= = Sτ
It Iτ Pτ It Iτ

where Sτ = Pτ /Pτ . Note that a di¤erent choice of τ may lead to a

di¤erent result

Pasquale Della Corte (Imperial) International Finance Lecture 3 32 / 61

Computing the Real Exchange Rate

Real exchange rate as follows

1
P It Iτ
Qt = St t = St Sτ
Pt It Iτ

You can see that at time τ

1
P Iτ Iτ
Qτ = Sτ τ = Sτ Sτ =1
Pτ Iτ Iτ

Pasquale Della Corte (Imperial) International Finance Lecture 3 33 / 61

Computing the Real Exchange Rate

Naive computation

Date $/SFr $ CPI SFr CPI

1 1973Q1 0.3523 28.20 46.82
2 1973Q2 0.4124 28.82 47.73
3 1973Q3 0.4140 29.45 48.15
4 1973Q4 0.3700 30.14 49.10
5 1974Q1 0.3964 30.99 50.27

P2 47.73
Q2 = S2 = 0.4124 = 0.68
P2 28.82

CHF is undervalued wrt to USD approximately by 32% (wrong !!!)

Pasquale Della Corte (Imperial) International Finance Lecture 3 34 / 61

Computing the Real Exchange Rate

Assume that PPP holds at time 1

Date $/SFr $ CPI SFr CPI

1 1973Q1 0.3523 28.20 46.82
2 1973Q2 0.4124 28.82 47.73
3 1973Q3 0.4140 29.45 48.15
4 1973Q4 0.3700 30.14 49.10
5 1974Q1 0.3964 30.99 50.27

I2 I1 1 28.82 46.82 1
Q2 = S2 S1 = 0.4124 0.3523 = 1.17
I2 I1 47.73 28.20

CHF is overvalued wrt to USD approximately by 17%.

Pasquale Della Corte (Imperial) International Finance Lecture 3 35 / 61

The Big Mac Index
Ever since 1986, the Economist has published the Big Mac Index
a non conventional way of measuring PPP
Big Mac burger is common market basket
sold in 120 countries around the world

The Big Mac Spot Rate

the exchange rate that would make a burger costs the same in each
country
PBigMac ,t
St =
PBigMac ,t
The Big Mac Real Exchange Rate
foreign price in US$ relative to US price (in US$)
St PBigMac ,t
Qt =
PBigMac ,t
measures whether a currency is overvalued or undervalued wrt the
USD
Pasquale Della Corte (Imperial) International Finance Lecture 3 36 / 61
The Big Mac Index

Key points Big Mac Index

India ( 67%), South Africa ( 53%), Hong Kong ( 50%), Russia

( 43%) and China ( 41%) among the cheapest currencies
Norway (+69%), Switzerland (+55%), Sweden (+36%), and Brazil
(+14%) among the most expensive
among the advanced economies, Japan ( 36%)

Shortcomings
re‡ects non-tradable components (rent and wages)
does not account for shipping costs, local taxes, levels of competition,
and import duties a¤ect arbitrage
is a good measure when comparing countries at the same stage of
development

Pasquale Della Corte (Imperial) International Finance Lecture 3 37 / 61

E¤ective Exchange Rate

Countries are interested in the level of their competitiveness against a

set of trade competitors
bilateral exchange rate as a measure of bilateral competitiveness
e¤ective exchange rate as a measure of multilateral competitiveness

The e¤ective exchange rate (EER) measures the value of the

domestic currency with respect to a basket of foreign currencies

The nominal e¤ective exchange rate (NEER) is a weighted

average of bilateral nominal exchange rates

The real e¤ective exchange rate (REER) is a weighted average of

bilateral real exchange rates and is used as a measure of multilateral
competitiveness

Pasquale Della Corte (Imperial) International Finance Lecture 3 38 / 61

E¤ective Exchange Rate

Both NEER and REER are constructed using trade-based weights

capturing both direct market and third-market competition

Direct market competition

domestic and foreign …rms compete at home (imports) and in the
foreign market (exports)

Third-market competition
domestic and foreign …rms also compete in a third country economy

The Fed, ECB, BIS and IMF regularly publish nominal and real
e¤ective exchange rates.

Pasquale Della Corte (Imperial) International Finance Lecture 3 39 / 61

 effective exchange rates, following an update of the associated trade weights and an extension of
the list of the euro area’s trading partners. The weights are based on exports and imports (exclud-
EUR Effective Exchange Rate: ECB Weights
ing intra-euro area trade), where the exports are double-weighted to capture the competition faced
by euro area exporters in foreign markets (third-market effects); see Figure 20.7.

Figure 20.7 Euro: effective index weights, EER-23

Weights in the EER-23 indices

USA
UK
Japan
China
Switzerland
Sweden
S. Korea
Poland
Singapore
Czech Rep.
Hungary
Denmark
Hong Kong
Canada
Norway
Australia
Slovakia
Slovenia
Estonia
Lithuania
Cyprus
Malta
Latvia

0 4 8 12 16 20 24

Reference period 1995–1997 Reference period 1999–2001

Data source: ECB (2004, box 10).

Pasquale Della Corte (Imperial) International Finance gLecture 3 40 / 61

E¤ective Exchange Rate

The EER is constructed as an index with base year equal to 100 and
with the perspective of foreign countries BIS E¤ective Rates

Nominal E¤ective Exchange Rate (NEER)

NEERt > 100 : domestic currency is appreciating relative to its trade
competitors
NEERt < 100 : domestic currency is depreciating relative to its trade
competitors

Real E¤ective Exchange Rate (REER)

RERt > 100 : domestic currency is overvalued relative to its trade
competitors
REERt < 100 : domestic currency is undervalued relative to its trade
competitors

Pasquale Della Corte (Imperial) International Finance Lecture 3 41 / 61

USD Real Effective Exchange Rate

Pasquale Della Corte (Imperial) International Finance Lecture 3 42 / 61

Empirical Evidence

In the late 70s, the validity of PPP was tested

st = α + βpt + β pt + εt

under the null that PPP holds

α = 0 =) no constant deviations from parity condition
β = 1 and β = 1 (homogeneity and symmetry)

Results
PPP generally holds for high in‡ation countries (Frenkel, 1978)
otherwise, PPP is strongly rejected

Drawback
are deviations (εt ) from PPP temporary or permanent deviations?
what is the behavior of RER?
Pasquale Della Corte (Imperial) International Finance Lecture 3 43 / 61
Empirical Evidence

PPP is rejected and deviations from PPP are permanent

short-run deviations from PPP do not disappear over time, RER is a
random walk process and disconnected from PPP

PPP is rejected but deviations from PPP are temporary

short-run deviations tend to vanish over time, RER is a mean-reverting
process suggesting a long-run validity for PPP

Testing for stationarity in RER (does qt evolve around zero?)

qt = c + φqt 1 + ηt

if φ = 1 =) qt is a random walk process (nonstationary process)

if jφj < 1 =) qt is a mean-reverting process (stationary process)

Pasquale Della Corte (Imperial) International Finance Lecture 3 44 / 61

Empirical Evidence

Long span data

Frenkel (1986) examines the dollar-sterling RER from 1869 to 1984
Lothian and Taylor (1996) use 200 years of data for dollar-sterling and
franc-sterling RER
RER is a mean-reverting process using long span data (cover di¤erent
exchange rate regimes and subject to structural breaks)

Short span data

the analysis generally focuses on the recent ‡oating period (1973 or
1976 onwards)
the real exchange displays slow mean-reversion and statistical tests fail
to reject the null hypothesis of non-stationarity
the power of a statistical test depends on the span and not on the
frequency of the data (Perron and Shiller, 1985)

Pasquale Della Corte (Imperial) International Finance Lecture 3 45 / 61

Empirical Evidence

First PPP puzzle

lack of evidence in favor of long-run PPP for the recent ‡oating period

Second PPP puzzle

“How can we reconcile the enormous short-term volatility of real
exchange rate with the extremely slow rate at which shock appear to
damp out?” (Rogo¤, 1996)
how can we explain large and persistent deviations from PPP?

Do rigidities in nominal prices and wages play a role? If so, nominal

exchange rate volatility may cause deviations from PPP
estimated half-life of deviations from PPP is between 3 and 5 years
half-life: time it takes for half the e¤ects of a given shock to dissipate
half-life cannot be explained by rigidities in nominal prices and wages
Pasquale Della Corte (Imperial) International Finance Lecture 3 46 / 61
Half-life and Real Exchange Rate
Suppose qt is described by a stationary AR(1) process

qt = c + φqt 1 + εt , jφj < 1

This process is reverting to its mean c/ (1 φ) by construction
we want to quantify the speed of the mean reversion or the half-life
the time horizon the process needs on average to halve its distance
from the mean.

Set c = qt 1 = 0, and consider a shock at t such that qt = εt

the expected value h time period ahead is Et (qt +h ) = φh εt
the half-life is simply the time period h it takes for the expected value
of q to half the shock ε1
1 ln 0.5
φh εt = εt =) h =
2 ln jφj

Pasquale Della Corte (Imperial) International Finance Lecture 3 47 / 61

Half-life and Real Exchange Rate
Using post-1973 data, Mark (2001) reports the following estimates

Country φ Half-life
Australia 0.86 4.6
Germany 0.79 3.0
Japan 0.93 9.3
Norway 0.77 2.7
Sweden 0.88 5.5
Switzerland 0.73 2.2
United Kingdom 0.74 2.3

Since the OLS estimator of φ is biased downward in small sample,

Mark (2001) uses the bias-adjustment of Kendall (1954)
T φOLS + 1
φ =
T 3

Pasquale Della Corte (Imperial) International Finance Lecture 3 48 / 61

Long-Runpurchasing
Evidence power parity 17

UK and US prices and the spot dollar-sterling rate (in logs)

9
US CPI
8 UK CPI
7 Spot rate
6
5
4
3
2
1
0
91

03

15

27

39

51

63

75

87

99

11

23

35

47

59

71

83

95
17

18

18

18

18

18

18

18

18

18

19

19

19

19

19

19

19

19
The real dollar-sterling exchange rate (in logs)
0.4
0.3
0.2
0.1
−0.0
−0.1
−0.2
−0.3
−0.4
91

04

17

30

43

56

69

82

95

08

21

34

47

60

73

86

99
17

18

18

18

18

18

18

18

18

19

19

19

19

19

19

19

19
Figure 1 200 years of prices and exchange rates. Sources: 1791–1991: Lothian and
Pasquale Della Corte (Imperial) International Finance Lecture 3 49 / 61
Performance of a Test

Type I Error: to reject H0 when H0 is true

Type II Error: not to reject H0 when H0 is false

Size of a test: we want the size Power of a test: we want the power to
to be small (low type I error) be close to one, low type II error)

State of Nature
Decision H0 is True H0 is False
Type I Error Correct Decision
Reject H0
(α) (1 β )
Correct Decision Type II Error
Do not reject H0
(1 α ) ( β)
There is a trade off between them: we set the Pr(type I error) at a
given level (0.05) and leave the Pr(type II error) undertermined)

The power of a statistical test is the probability of rejecting the null

hypothesis when H0 is false, i.e., 1 β

Pasquale Della Corte (Imperial) International Finance Lecture 3 50 / 61

The Power Problem

Lothian and Taylor (1996)

obtain the following estimate for dollar-sterling on annual data

qt = 0.18 + 0.89qt 1 + εt

adjustment is 11% per annum

Question
what is the probability that a unit root test will reject the null
hypothesis if this is the type of process driving the real exchange rate?

Unit Root Test

it tests the presence of a unit root test in an autoregressive model
under the null hypothesis the process is non-stationary

Pasquale Della Corte (Imperial) International Finance Lecture 3 51 / 61

The Power Problem

A simple experiment

T 20 25 50 75 100 150 200

1 β 6.99 7.95 15.13 26.03 41.26 75.13 93.80

Bottom Line
100 years of data may well not be su¢ cient!!
usually the autoregressive parameter is very close to unity so that it is
very hard to discriminate empirically whether it is below unity or not.
conventional unit root tests (such as the Dickey-Fuller test) lack power.

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Balassa-Samuelson Hypothesis

Suppose a country experiences high productivity growth in its

traded-goods sector, where the law of one price holds. Wages will
increase in this sector but not prices, set by international competition

Because the country draws its labour from a single domestic market,
the non-traded sector will claim for comparable wages. Such increase
will cause an increase in the non-traded goods prices and in the
overall CPI index

Nominal exchange rate does not change because the price of traded
goods is not a¤ected. Since PPP is measured using the CPI index,
the domestic currency will appear overvalued

Consumer price levels in wealthier countries are systematically higher

than in poorer ones

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Fisher Hypothesis
An increase in the expected rate of in‡ation (Et π t +1 ) will cause a
proportionate increase in the nominal interest rate it

1 + it = (1 + rt )(1 + Et π t +1 )

which implies
1 + it it Et π t +1
rt = 1 =) rt =
1 + Et π t + 1 1 + Et π t + 1
For low in‡ation country

rt it Et π t + 1

where rt is the real interest rate

The real interest rate equals approximately the nominal

interest rate minus the expected in‡ation rate
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PPP and UIP: What is the implication?

UIP
St + 1 St
Et it it
St

Ex-ante Relative PPP

St + 1 St
Et Et ( π t + 1 π t +1 )
St

What if both UIP and PPP hold?

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PPP and UIP: What is the implication?

Matching PPP and UIP

it it = Et (π t +1 π t +1 )

implies the Fisher Hypothesis real returns across countries

it Et π t +1 = it Et π t + 1

rt = rt

The real interest rate should be the same across countries if both
UIP and PPP hold

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Value Strategy

The empirical evidence on PPP is the basis for the value strategy
select a pool of currencies (e.g., G10) using the BIS survey
for each currency κ, compute the RER relative to USD as
St St
Qtκ = $
=
Pt /P κ t
PPP Spot Rate

for instance, the OECD publishes annually the PPP spot rate for a
wide set of countries: construct Qtκ by updating the numerator every
period whereas the denominator is …xed for a year
OECD Stats =) General Statistics =) Reference Series =) Price
and Purchasing Power Parities OECD Stats
The OECD PPP spot rate is de…ned as units of foreign currency per
dollar unit BUT you need units of US dollars per foreign currency unit.

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Value Strategy

At time t (end of month)

group currencies into 3 equally-weighted portfolios using Qtκ
P1: top 3 undervalued currencies (lowest Qtκ )
P3: top 3 overvalued currencies (highest Qtκ )
buy P1 (undervalued currencies) and sell P3 (overvalued currencies)

At time t + 1 (end of next month)

compute the excess return for each currency as

rxtκ+1 = Stκ+1 Ftκ /Stκ

take the equally-weighted average withing each basket, and compute

the value excess return as
rxtκ+1 rxtκ+1
valuet +1 = ∑ 3 ∑ 3
κ 2P 1 κ 2P 3

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Value Strategy: Cumulative Wealth
1.8

1.6

1.4

1.2

Carry Value
1

In the long-run, currencies tend to move towards their 'fair value': buying
'undervalued' currencies and selling 'overvalued' currencies is profitable
on average in the medium-term.
0.8

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Key Concepts

Absolute Purchasing Power Parity

Relative Purchasing Power Parity

Real Exchange Rate

Real E¤ective Exchange Rate

Overvalued/Undervalued Currency

PPP Puzzles

Balassa-Samuelson Hypothesis

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Readings

Bekaert and Hodrick, Ch. 8 & 9.

Taylor, A.M. and M.P. Taylor (2004). “The Purchasing Power Parity
Debate,” Journal of Economic Perspectives, 18, 135-158.

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