In this assignment I am going to look at the theory behind Purchasing Power Parity PPP, and the potential reasons why PPP may not hold. I will then be looking at the value of a can of Coca-Cola in several different countries and demonstrating the variance in price and whether PPP holds, therefore giving an indication on whether or not a currency is over or undervalued in relation to a can of coke. I will also be assessing reasons for this variance and relating this back to the theory.
Purchasing Power Parity is based on the “law of one Price” ‘In its simplest form, the purchasing power parity exchange rate can be thought of as the level of the nominal exchange rate such that the purchasing power of a unit of currency is exactly the same in the foreign economy as in the domestic economy, once it is converted into foreign currency at that rate’. Taylor (2003, 437). If this is the case then there is no discrepancy in the price of two goods in two different countries indicating that the exchange rate is efficient and that there is no over or undervaluation of currencies, PPP holds.
If PPP is to hold then the following formula reads true,
Pt = Pt* St
Where Pt is the price level of the domestic currency, Pt* is the corresponding price level in the foreign currency and St denotes the exchange rate. However if this did not balance and Pt is greater, than Pt* St Then the home (foreign) currencies are over (under) valued and vice versa.
A real exchange rate can be drawn from PPP. A real exchange rate is the exchange rate that is adjusted by price of the same goods in two different countries; it can be represented as follows:
Q = St (Pt*/ Pt)
Where Q is the real exchange rate. The real exchange rate can be used to assess the weakness or strength of a currency.
Purchasing Power Parity is a way of looking at whether a currency is over or undervalued. PPP indicates what you can buy in... [continues]
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