ppp theory

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International TradeInternational Trade

TheoryTheoryPurchasing Power ParityPurchasing Power Parity

TheoryTheory

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Formulated by Gustan Cassel in 1920.Formulated by Gustan Cassel in 1920.

Theory formulated during period when inflationTheory formulated during period when inflationwas very high.was very high.

The theory puts forward the idea that whenThe theory puts forward the idea that whencurrencies are exchanged among nations, theircurrencies are exchanged among nations, theirpurchasing power is only transferred.purchasing power is only transferred.

This means that a person should be able to buyThis means that a person should be able to buy

the same amount of goods in either country ,the same amount of goods in either country ,when expressed in either countrys currency.when expressed in either countrys currency.

The theory suggests that the principleThe theory suggests that the principledeterminant of exchange rate is the difference indeterminant of exchange rate is the difference inNational Inflation Rates.National Inflation Rates.

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This means , a country where costs and prices are relatively lessThis means , a country where costs and prices are relatively lessthan another country will find its currency appreciating.than another country will find its currency appreciating.

The law of one price is usually the basis to interpret this theory.The law of one price is usually the basis to interpret this theory.

According to this law, after making allowances for tariff andAccording to this law, after making allowances for tariff andtransport costs, the price of goods in one country should nottransport costs, the price of goods in one country should notsignificantly differ from that in another country.significantly differ from that in another country.

P= EP*.P= EP*.

Where P is the price of the product in domestic countryWhere P is the price of the product in domestic country

P* is the price of same product in a foreign countryP* is the price of same product in a foreign country

E= domestic currency price of the foreign currency.E= domestic currency price of the foreign currency.

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If P and P* can be interpreted as the domesticIf P and P* can be interpreted as the domesticand foreign price index, representing theand foreign price index, representing therespective inflation figures , the exchange ratesrespective inflation figures , the exchange ratesbecomes the ratio of relative price levels in thebecomes the ratio of relative price levels in the

two countries.two countries.

An important application of the PPP theory is thatAn important application of the PPP theory is thatthe nominal exchange rate must adjustthe nominal exchange rate must adjustsignificantly and sufficiently so as to reflectsignificantly and sufficiently so as to reflect/compensate the underlying inflation difference./compensate the underlying inflation difference.

Once this happens, the internationalOnce this happens, the internationalcompetitiveness of any countrys product I thecompetitiveness of any countrys product I theworld market shall be maintained.world market shall be maintained.

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As per PPP theoryAs per PPP theory

The real Exchange rate= NominalThe real Exchange rate= Nominalexchange rate * Foreign price index/exchange rate * Foreign price index/

domestic price index.domestic price index. = 44 *100/110= 40= 44 *100/110= 40

where 44= exchange ratewhere 44= exchange rate

100= foreign price index and 110=100= foreign price index and 110=

domestic price index which has increaseddomestic price index which has increasedto 110 due to inflation.to 110 due to inflation.

The real exchange rate appreciates to 40.The real exchange rate appreciates to 40.

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This adversely affects the exporters ability toThis adversely affects the exporters ability tocompete globally due to the fact that if a UScompete globally due to the fact that if a USimporter pays $ 1 for a product , the Indianimporter pays $ 1 for a product , the Indianexporter will get Rs 44 , which is the nominalexporter will get Rs 44 , which is the nominal

exchange rate, which is worth only Rs 40 becauseexchange rate, which is worth only Rs 40 becauseof effect of inflation in India.of effect of inflation in India.

Thus to maintain the real exchange rate as 44,Thus to maintain the real exchange rate as 44,the nominal exchange rate should depreciate bythe nominal exchange rate should depreciate by10% i.e 48.4 in this example.10% i.e 48.4 in this example.

Then the exporter get the true value of 44Then the exporter get the true value of 44(which is the real exchange rate)(which is the real exchange rate)

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The essence of this theory is thatThe essence of this theory is thatone must export to a country whoseone must export to a country whose

inflation rate is higher than theinflation rate is higher than thedomestic inflation rate.domestic inflation rate.

In the case of imports, one mustIn the case of imports, one mustimport from a country whoseimport from a country whose

inflation rate is lower than theinflation rate is lower than thedomestic country.domestic country.

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Drawbacks of PPP theory:Drawbacks of PPP theory:

Doesnt take into account actual

Doesnt take into account actualpractice factors such as currentpractice factors such as current

account performance, portfolioaccount performance, portfoliodecisions, interest rates, economicdecisions, interest rates, economic

growth and central banksgrowth and central banksintervention, which have an effect onintervention, which have an effect onthe variations in exchange rates.the variations in exchange rates.

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Classical Theories of International Trade.Classical Theories of International Trade.

The classical theories of international trade1 wereThe classical theories of international trade1 weresuggested by Adam Smith, David Ricardo, J.S. Mill. Thesuggested by Adam Smith, David Ricardo, J.S. Mill. Thebasic assumptions of the classical theories are:basic assumptions of the classical theories are:

2 x 2 x 1 model (implying two countries, two products and2 x 2 x 1 model (implying two countries, two products and

single factor of production).single factor of production). Perfect competition in both output and input markets.Perfect competition in both output and input markets. Homogenous laborHomogenous labor Mobility of labor internally and immobility internationallyMobility of labor internally and immobility internationally Constant returns to scaleConstant returns to scale Free tradeFree trade No transportation costsNo transportation costs Labor theory of valueLabor theory of value Full employment of factors of production.Full employment of factors of production.

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JJ..SS.. MillMill hashas restatedrestated thethe RicardianRicardian theorytheory inintermsterms ofof comparativecomparative advantageadvantage oror comparativecomparativeeffectivenesseffectiveness ofof laborlabor inin orderorder toto examineexamine thethequestionquestion ofof internationalinternational valuevalue (i(i..ee.. thethe ratiosratios atat

whichwhich goodsgoods wouldwould exchangeexchange forfor oneone another)another)..

RicardoRicardo hashas takentaken thethe givengiven outputoutput ofof eacheachcommoditycommodity inin termsterms ofof differingdiffering laborlabor costscosts..

MillMill onon thethe otherother handhand hashas assumedassumed aa givengivenamountamount ofof laborlabor inin eacheach countrycountry andand consideredconsidereddifferingdiffering outputoutput ofof thethe twotwo goodsgoods duedue toto differingdifferinglaborlabor efficiencyefficiency..

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AccordingAccording toto MillsMills DoctrineDoctrine ofof ReciprocalReciprocal Demand,Demand, thetheactualactual ratioratio atat whichwhich goodsgoods exchangeexchange betweenbetween thethe twotwocountriescountries willwill dependdepend onon aa reciprocalreciprocal demanddemand..

ReciprocalReciprocal demanddemand meansmeans thethe relativerelative strengthstrength andand

elasticityelasticity ofof demanddemand ofof twotwo tradingtrading countriescountries forfor eacheachothersothers productproduct inin termsterms ofof theirtheir ownown productproduct..

AA stablestable ratioratio ofof exchangeexchange willwill bebe fixedfixed atat thethe pointpoint atat whichwhichthethe valuevalue ofof importsimports andand exportsexports ofof eacheach countrycountry isis ininequilibriumequilibrium..

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Offer Curves

Offer Curves

How the Terms of Trade AreHow the Terms of Trade Are

EstablishedEstablished

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Offer Curves areOffer Curves are

all combinations of a countrysall combinations of a countrysdesired exports and imports atdesired exports and imports at

different terms of tradedifferent terms of trade also known as reciprocal demandalso known as reciprocal demand

curves (J.S. Mills)curves (J.S. Mills)

measures ofmeasures of willingness to tradewillingness to trade

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Offer CurvesOffer Curves

Offer curves representOffer curves represent willingness towillingness totradetrade at every possible terms ofat every possible terms of

tradetrade As the relative price of good X rises,As the relative price of good X rises,

Country A becomes willing to exportCountry A becomes willing to exportmore and import moremore and import more

Offer curves bow towards theOffer curves bow towards theimport good axisimport good axis

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Terms ofTrade EquilibriumTerms ofTrade Equilibrium

The international terms of trade (thatThe international terms of trade (thatis, Pis, PXX/P/PYY) will be the slope of a line) will be the slope of a line

passing through the point where thepassing through the point where theoffer curves cross.offer curves cross.

This equilibrium point takes intoThis equilibrium point takes intoaccount demand and supplyaccount demand and supply

conditions in both countriesconditions in both countries

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Y

X

(PX/PY)E

X1

Y1

OCA

OCB

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Y

X

(PX/PY)E

X1

Y1If these are the terms of trade,

country A will desire to export

X1 units, and country B willwant to import X1 units

OCA

OCB

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Y

X

(PX/PY)E

X1

Y1If these are the terms of trade,

country A will desire to import

Y1 units, and country B willwant to export Y1 units

OCA

OCB

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How Do We Know ItsHow Do We Know Its

Equilibrium?Equilibrium? Any terms of trade other thanAny terms of trade other than

(P(PXX/P/PYY))EE will result inwill result in

excess demand for one goodexcess demand for one good excess supply for the otherexcess supply for the other

Therefore relative prices will adjustTherefore relative prices will adjustuntil (Puntil (PXX/P/PYY))

EE is reachedis reached

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DisequilibriumDisequilibrium

Y

X

(PX/PY)1

OCA

OCB

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Y

X

(PX/PY)1

OCA

OCBY1

Y2

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Y

X

(PX/PY)1

OCA

OCBY1

Y2 At (PX/PY)1, country A wishes

to import Y1 units, but country B

is only interested in exporting Y2units. That is, there is an excess

demand for good Y.

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Y

X

(PX/PY)1

OCA

OCB

X1X2

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Y

X

(PX/PY)1

OCA

OCB

X1X2

At (PX/PY)1, country A wishes

to export X1 units, but country B

is only interested in importing X2units. That is, there is an excess

supply of good X.

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Excess demand for Y causes PExcess demand for Y causes PYY totoriserise

Excess supply of X causes PExcess supply of X causes PXX to fallto fall Thus, (PThus, (PXX/P/PYY) falls) falls

In other words, the terms of tradeIn other words, the terms of tradeline gets flatter, moving theline gets flatter, moving thecountries in the direction ofcountries in the direction ofequilibriumequilibrium

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Moving Towards EquilibriumMoving Towards Equilibrium

Y

X

(PX/PY)1

OCA

OCB

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Terms of trade lines that are flatterTerms of trade lines that are flatterthan (Pthan (PXX/P/PYY))

EE, such as, such as

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Y

X

(PX/PY)2

OCA

OCB

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Terms of trade lines that are flatterTerms of trade lines that are flatterthan (Pthan (PXX/P/PYY))

EE will results inwill results in

an excess demand for good Xan excess demand for good X an excess supply of good Y, and soan excess supply of good Y, and so

(P(PXX/P/PYY) will rise) will rise

That is, the terms of trade line willThat is, the terms of trade line willget steeper until (Pget steeper until (PXX/P/PYY))

EE is reachedis reached

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Moving Towards EquilibriumMoving Towards Equilibrium

Y

X

(PX/PY)2

OCA

OCB

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A Note on the Terms ofTradeA Note on the Terms ofTrade

A countrys terms of trade areA countrys terms of trade arethe price of its exports divided bythe price of its exports divided bythe price of its imports, so a risingthe price of its imports, so a risingterms of trade is good newsterms of trade is good news

In this example, (PIn this example, (PXX/P/PYY) is country) is countryAs terms of trade, since A exportsAs terms of trade, since A exports

good X and imports Ygood X and imports Y (P(PYY/P/PXX) is country Bs terms of) is country Bs terms of

trade in this exampletrade in this example

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A Note on the Terms ofTrade,A Note on the Terms ofTrade,

continuedcontinued As As terms of trade (PAs As terms of trade (PXX/P/PYY))

improve, Bs terms of trade (Pimprove, Bs terms of trade (PYY/P/PXX))must be deteriorating and vicemust be deteriorating and vice--versaversa

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Shifts ofOffer CurvesShifts ofOffer Curves

Anything that causes country AsAnything that causes country Aswillingness to trade to change willwillingness to trade to change willshift As offer curveshift As offer curve

increased willingness to trade: OCincreased willingness to trade: OCAAshiftsshifts rightright

decreased willingness to trade: OCdecreased willingness to trade: OCAA

shiftsshifts leftleft These can be caused byThese can be caused by

changes in demand conditions orchanges in demand conditions or

changes in supply conditionschanges in supply conditions

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Demand Changes in Country ADemand Changes in Country A

Y

X

(PX/PY)E

X1

Y1

OCA

OCB

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Y

X

(PX/PY)E

OCA

OCB

Increased demand for imports

by Country A causes arightward shift of As offer

curve

OCA'

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Y

X

(PX/PY)E

OCA

OCB

Volume of trade increases, but

As terms of trade go down. Bs

terms of trade improve.

OCA'

(PX/PY)E'

X2

Y2

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Demand Changes in ADemand Changes in A

Any change that might make AAny change that might make Ademand more imports leads to ademand more imports leads to arightward OC shift, and thusrightward OC shift, and thus

an increase in trade volumean increase in trade volume

a decrease in As terms of tradea decrease in As terms of trade

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Demand Changes in Country BDemand Changes in Country B

Y

X

(PX/PY)E

X1

Y1

OCA

OCB

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Y

X

(PX/PY)E

OCA

OCB

OCB'

Increased demand for imports

by Country B shifts Bs OCupward

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Y

X

(PX/PY)E

OCA

OCB

OCB'

(PX/PY)E'

X2

Y2

Volume of trade increases,

but Country Bs terms of trade

decrease (and As terms of

trade improve).

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Other Demand ChangesOther Demand Changes

Any decrease in a countrysAny decrease in a countryswillingness to trade will shift its OCwillingness to trade will shift its OCleftward or downwardleftward or downward

An example is when a countryAn example is when a countryimposes an import tariffimposes an import tariff

Tariffs therefore lead to decreasedTariffs therefore lead to decreased

trade volume, but improve thetrade volume, but improve theimposing countrys terms of tradeimposing countrys terms of trade

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Imposition ofTariffby CountryImposition ofTariffby Country

AAY

X

(PX/PY)E

X1

Y1

OCA

OCB

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AAY

X

(PX/PY)E

X1

Y1

OCA

OCB

OCA'

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AAY

X

(PX/PY)E

X2

Y2

OCA

OCB

OCA' (PX/PY)

E'

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AAY

X

(PX/PY)E

X2

Y2

OCA

OCB

OCA' (PX/PY)

E'

By imposing a tariff, Country A

decreases trade volume, andimproves its terms of trade (but

Bs terms of trade deteriorate)

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Supply ChangesSupply Changes

Changes in supply conditions willChanges in supply conditions willalso shift a countrys offer curvesalso shift a countrys offer curvesaroundaround

Examples includeExamples include

productivity changesproductivity changes

discovery of new resourcesdiscovery of new resources

ppp theory

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