Money, Banking, and International Finance

1.71 ringgits per U.S. dollar. However, the spot exchange rate equals 3.17 ringgits per U.S.
dollar. Consequently, we estimate in Equation 5 that the Malaysian ringgit is undervalued to the
U.S. dollar by approximately 46%. Dot above the Big Mac’s price is the percentage change in
price. Thus, analysts predict the ringgit will appreciate against the U.S. dollar over time.

100 =-46%

4. 33

2.33 4. 33

100

..

..

$

$ $

=

P

P P

P =

US

Malaysia US

BigMac





 

(5)

In general, the PPP tends to hold in the long run, but not the short run because of the
following reasons:

 Countries impose trade restrictions, such as tariffs and quotas. Moreover, many

governments impose trade restrictions on agricultural products. Countries use trade

restrictions to protect their industries from bacteria, viruses, insects, or a damaging plants

or species. For example, United States, Canada, and other countries ban importing British

beef to stop the spread of hoof-mouth disease.

 PPP emphasizes only price levels and exchange rates. The PPP does not include

transportation costs and transaction costs.

 PPP will not hold if governments define different baskets for their CPIs. Furthermore,

some goods and services are not tradable, such as haircuts, medical services, and real

estate. For example, land and housing construction are expensive in developed countries,

and relatively cheap in developing countries. Unfortunately, high-priced real estate hurls a

great cost on businesses, when they rent, buy, or lease buildings and space. Subsequently,

the businesses pass the greater cost onto products’ prices.

The Relative Purchasing Power Parity Theory is changes in products’ prices between
countries vary the exchange rate. Furthermore, the relative PPP assumes the legal system does
not change, and we define the notation as:

 We define the change in the domestic exchange rate as the foreign currency per one unit of

domestic currency.

 Foreign country’s inflation rate between now and time period T is f.

 Domestic country’s inflation rate between now and T is d.

 ST and S 0 are the domestic exchange rates measured at times 0 and T. Thus, the exchange

rate at Time 0 is

d

f

P

P

S 0 = , and Time T is

 

d d

f f

T

P + π

P + π

S =

1

1

.