where e equals the nominal exchange rate and P price.
If I buy a bike in Sweden for 1000:- this means the same bike should, in theory cost £100 to buy in UK which gives us a nominal exchange rate of 10. If a bike would sell for any price higher in UK, there would be a clear advantage for consumers to go to Sweden to buy bikes (remember that factors such as travelling costs are neglected in this example). Also, it would be beneficial for traders to go to Sweden and buy bikes and sell them in UK for a profit, also called arbitrage. However, this kind of activity would slowly drive prices higher in Sweden and lower in UK and in the end resulting in market equilibrium based on the theory of supply and demand (Mankiw & Taylor, 2006). This leads us to the Purchasing Power Parity theory which states that price differences between countries in the long run is not sustainable because the market will drive the prices to equilibrium and that “a currency must have the same purchasing power in all countries” (Mankiw & Taylor, 2006 p.650). “Purchasing Power Parities (PPPs) are currency conversion rates that both convert to a common currency and equalise the purchasing power of different currencies. In other words, they eliminate the differences in price levels between countries in the process of conversion.” (OECD, 2010) The PPP can be expressed in either absolute or relative terms. The absolute theory on measuring exchange rates is the one mentioned above and is the theory this paper will mainly focus on. The other version, relative, is based on price movements. (Ong, 2003) It states that the inflation rate between two countries must be the same if the exchange rate is going to stay the same. That is, if the inflation in one country X is higher than the country Y, its exchange rate will depreciate against country Y exchange rate based on the following formula: % e = % Inflationx -% Inflationy
where e is the change in exchange rate.
As stated above, the absolute PPP theory is mainly used as a tool of measuring how a currency is valuated and whether it’s under or over valuated. One very popular way to do this is using the Big Mac index (See appendix A) put together by The Economist. The Big Mac index is an index of how much a Big Mac costs in different countries. With this index we can compare the predicted exchange rate with the actual exchange rate to how a country’s currency is valued. When we compare the PPP we use a basket of goods which is identical in the comparing countries, in this case our basket is a Big Mac. When doing this we can predict an...