FINS3616 · International Business Finance
Purchasing Power Parity and Inflation
Week 2 of UNSW FINS3616 develops the law of one price and purchasing power parity (Shapiro Ch 4): absolute PPP as a level condition (e₀ = P_home/P_foreign) and relative PPP as a change condition that ties expected inflation differentials to expected exchange-rate movements. It also defines and computes the real exchange rate and explains why PPP fails in the short run but holds as a long-run tendency. PPP is examined in the 35% mid-term and is the empirical backbone of the 25% FACTSET iLab project, where you test inflation differentials against real currency data.
What this chapter covers
- 01Law of one price: exchange-adjusted prices of identical tradable goods are equal worldwide, enforced by arbitrage (the cross-listed-share illustration)
- 02Absolute PPP: P_h = e × P_f ⇒ e₀ = P_h/P_f; the Big Mac index intuition; why it fails (shipping, tariffs, non-traded goods)
- 03Relative PPP: e_t = e₀ × [(1+i_h)/(1+i_f)]^t — the higher-inflation currency depreciates
- 04The intuitive approximation %Δe ≈ i_h − i_f and the 45° 'parity line' picture
- 05PPP-based forecasting: project the future spot from inflation differentials (fundamental analysis)
- 06The real exchange rate e_real = e_nom × (P_foreign/P_home) and its competitiveness effect
- 07Empirical evidence: PPP fails short-run (sticky prices, index construction, non-traded goods) but currencies drift toward PPP rates long-run
- 08Where PPP sits among the five parity relationships and its link to the iLab regression
Relative PPP: projecting the future spot rate from inflation differentials
- +1State relative PPP: e_t = e₀ × [(1 + i_h)/(1 + i_f)]^t, with e quoted as the home-currency (USD) price of one rupee. The higher-inflation currency depreciates.
- +1Form the annual ratio: (1 + i_h)/(1 + i_f) = 1.025/1.060 = 0.96698. Raise to t = 3: 0.96698³ = 0.90419.
- +1Multiply by the spot: e₃ = 0.0700 × 0.90419 = 0.06329 ≈ 0.0633 USD per rupee. The rupee is expected to fall from 0.0700 to 0.0633.
- +1Approximate move: %Δe ≈ i_h − i_f = 2.5% − 6.0% = −3.5% per year — the rupee (the higher-inflation currency) depreciates by about 3.5% a year, compounding to roughly −9.6% over three years (0.90419 − 1). The USD price of a rupee falls, exactly as PPP predicts.
Key terms
- Law of one price (LOP)
- In competitive markets without frictions, exchange-adjusted prices of identical tradable goods or assets are equal worldwide (within transaction costs), enforced by arbitrage. It is the foundation for all the parity conditions.
- Absolute PPP
- Identical goods have the same price across countries in a common currency: P_h = e × P_f, so e₀ = P_h/P_f. In practice prices are proxied by a CPI basket; absolute PPP fails empirically because of shipping costs, tariffs, trade barriers and non-traded goods.
- Relative PPP
- The exchange rate changes to offset inflation differentials: e_t = e₀ × [(1+i_h)/(1+i_f)]^t, with the approximation %Δe ≈ i_h − i_f. The higher-inflation currency depreciates.
- Real exchange rate
- The nominal rate adjusted for relative price levels, e_real = e_nom × (P_foreign/P_home). A constant real rate is exactly the condition under which relative PPP holds; a rising real home currency erodes export competitiveness.
- Parity line
- The 45° line on which the exchange-rate change exactly equals the inflation differential (the intuitive PPP approximation). Points off the line represent disequilibria that arbitrage/adjustment push back toward the line.
- Non-traded goods
- Goods and services (housing, haircuts, local services) that cannot be arbitraged across borders. Their presence, along with sticky prices and index construction, is a key reason absolute PPP fails and relative PPP holds only as a long-run tendency.
Purchasing Power Parity and Inflation FAQ
What is the difference between absolute and relative PPP?
Absolute PPP is a level statement — it says what the exchange rate should be right now: e₀ = P_home/P_foreign, so identical goods cost the same everywhere in a common currency. Relative PPP is a change statement — it says how the exchange rate should move: e_t = e₀ × [(1+i_h)/(1+i_f)]^t, so the currency of the higher-inflation country depreciates. Absolute PPP fails badly in the data because of shipping, tariffs and non-traded goods, but relative PPP holds reasonably as a long-run tendency.
Why does PPP fail in the short run but hold in the long run?
In the short run goods prices are sticky while exchange rates move fast, price indices are built from different baskets, and many goods are non-traded and can't be arbitraged. So the exchange rate can drift far from its PPP value for years. Over longer horizons, though, persistent inflation differentials do get reflected in the currency, and rates drift back toward PPP-predicted levels — which is why the iLab expects the regression fit to improve at longer horizons.
How does PPP connect to the FACTSET iLab project?
The iLab has you model an assigned currency versus the Australian dollar using real quarterly FACTSET data, and PPP is the economic hypothesis behind it: because PPP is a long-run relationship, the exchange-rate change should track the inflation differential better over longer horizons, so the regression's fit (adjusted R² and the F-test) should improve as you move from a 1-quarter to a 3-year change. You test that empirically. Note that AI use is prohibited on the iLab, so use this guide to understand the method beforehand.
Can AI help me with PPP calculations in FINS3616?
Yes, for learning and mid-term practice. Sia is an AI tutor built to mirror how FINS3616 is taught and assessed at UNSW Sydney: it can walk you through an absolute-PPP valuation, a relative-PPP forecast, and the intuitive %Δe ≈ i_h − i_f approximation step by step, and check that you have the depreciation direction right. It does not do graded assessment for you — and remember the 25% iLab explicitly bans AI — so keep it to understanding the method, consistent with UNSW academic-integrity rules.
Exam move
Anchor the whole chapter on one question: which currency has the higher inflation? That currency must depreciate, which fixes the direction of every PPP answer and catches inverted ratios instantly. Practise both forms — the exact relative-PPP formula e_t = e₀[(1+i_h)/(1+i_f)]^t and the approximation %Δe ≈ i_h − i_f — and be able to say why they agree for small differentials. Keep absolute PPP (a level, e₀ = P_h/P_f) mentally separate from relative PPP (a change), because the mid-term tests both. Learn the empirical story cold — short-run failure from sticky prices, index construction and non-traded goods, long-run tendency toward PPP — because it is a standard short-answer question and it explains the horizon result you must produce in the iLab. Since PPP feeds both the 35% closed-book mid-term and the 25% FACTSET project, rehearse the calculations on the tutorial questions and practise the long-versus-short-horizon PPP reading on invented data (the iLab bans AI, so build the intuition now). When a step won't click, ask Sia to re-explain it and set a fresh two-country forecast.
Working through Purchasing Power Parity and Inflation in FINS3616? Sia is AskSia’s AI Business and Economics tutor — ask any FINS3616 Purchasing Power Parity and Inflation question and get a clear, step-by-step explanation grounded in how FINS3616 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
