International Finance: Putting Theory Into Practice

104 CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY

• But this ignores price differences. What you ”really” earn is 50/5 = 10 Big-
  Meals, while your friend makes 2000/250 = 8 BigMeals. That is, your friend
  is ”really” almost as well off as you are.

What’s thePPPrate?

To buy 8 BigMeals at home, you would need 8×5 =usd 40. So one way to
summarize the situation is thatfdk2000 means as much to your friend abroad as
usd40 means here, to you. Theusd40 is called the translation offdk2000 using
the Purchasing Power Parity rate rather than the nominal rate, and the impliedppp
rate is the 40/2000 = 0.020usdperfdk, the ratio of the two price levels.

Let’s generalize. Suppose you want to have a feel for what a fcamountY∗
“really” means to a foreigner. The question can be made more precise as follows:
Give me ahcamountYˆ such that its purchasing power here,Y /ˆ Πt, equals the
purchasing power abroad of the original amount,Y∗/Π∗t:

FindYˆ such that

Yˆ

Πt

=

Y∗

Π∗t

⇒Yˆ =

Πt

Π∗t

Y∗ (3.9)

= Sˆpppt Y∗,whereSˆpppt

def

=

Πt

Π∗t

(3.10)

So we can always compute theppprate as the ratio of the two price levels. For
example, your friend’s foreign amount (fdk2000) could have been translated at the
ppprate, 5/250 = 0.020, which would have told you immediately that her income
buys as much (in Freedonia) asusd40 buys here.

Example 3.15
End 2006, theCIAFactbook (http://www.cia.gov/cia/publications/factbook/geos/rs.html)
assessed Russia’s 2005gdpat 1.589usdtrillion using theppprate, and at 740.7
billion using the nominal official rate. What is the explanation: are prices lower in
Russia than in theus, or is it the inverse?

For China, the then figures were (purchasing power parity:) usd8.883 trillion
and (official exchange rate:)usd2.225 trillion), a ratio of about four to one instead
of Russia’s two to one. Which country, then, has the lower price level?

DoItYourself problem 3.2
Check that theppprate has dimensionhc/fc.

The IMFand the World Bank, for instance, often use ppprates rather than
the regular (“nominal”) rate to translate foreigngdp’s or incomes or government