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Parity conditions and forecasting - Purchasing power parity ...

ResourcesParity conditions and forecasting - Purchasing power parity ...

Learning Outcomes

After reading this article, you will be able to explain the concept of purchasing power parity (PPP), describe how relative inflation rates affect exchange rates, and apply PPP theory in forecasting. You will also understand the formula used, limitations of PPP in practical scenarios, and how inflation links to currency movements for ACCA Financial Management (FM).

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the relationship between inflation and exchange rates, and how parity conditions can be used to forecast currency values. Revision in this topic should focus on:

  • The concept and formula for purchasing power parity (PPP) theory
  • How relative inflation rates drive exchange rate changes
  • Application of PPP for forecasting future spot exchange rates
  • Limitations and practical considerations in using parity conditions for forecasts

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

  1. What principle does purchasing power parity (PPP) theory rely on when forecasting currency movements?
  2. If Country A expects 6% inflation and Country B 2%, what happens to Country A's currency, according to PPP theory?
  3. State the formula used to forecast future spot exchange rates using PPP.
  4. List one limitation of relying solely on PPP for real-world currency forecasting.

Introduction

Parity conditions link exchange rates to economic fundamentals, most notably inflation. Purchasing power parity (PPP) theory explains and predicts how differences in inflation between countries lead to changes in exchange rates over time. Understanding PPP and how to apply it to exchange rate forecasts, plus recognizing why PPP may not always match reality, is essential for candidates preparing for the ACCA FM exam.

Key Term: purchasing power parity (PPP)
The theory that the exchange rate between two currencies will move to reflect changes in relative price levels, so identical goods cost the same in each country when priced in a common currency.

Key Term: parity condition
An economic relationship that links two or more variables between countries, such as exchange rates and inflation or interest rates, ensuring no arbitrage opportunities arise.

Purchasing Power Parity (PPP) Theory

PPP is based on the "law of one price," which states that identical goods should sell for the same price in different countries when expressed in the same currency, assuming no barriers to trade and negligible transport costs. Parity is reached when exchange rates offset differences in price levels, preserving equal purchasing power.

PPP is divided into:

  • Absolute PPP: Direct equalization of price levels via exchange rate.
  • Relative PPP: Focuses on changes in price levels (i.e., inflation) and how these affect exchange rates over time.

The PPP Forecasting Formula

PPP suggests that the country with higher inflation should expect its currency to depreciate. The expected future spot rate (S1S_1) is:

S1=S0×1+hc1+hbS_1 = S_0 \times \frac{1 + h_c}{1 + h_b}

Where:

  • S1S_1 = expected future spot rate (quoted as counter currency/base currency)
  • S0S_0 = current spot rate
  • hch_c = expected inflation rate in the counter currency country
  • hbh_b = expected inflation rate in the base currency country

Key Term: spot rate
The current rate at which one currency can be exchanged for another for immediate delivery.

Key Term: base currency
In a currency pair, the first currency quoted and the one against which the other (counter currency) is compared.

How Inflation Impacts Exchange Rates

According to PPP, if inflation is higher in one country compared to another, that country's currency is expected to lose value (depreciate), as it will buy fewer goods both domestically and internationally. PPP theory ensures exchange rates adjust to neutralize differences in purchasing power.

Worked Example 1.1

A company notes that the spot rate between the US dollar and the UK pound is $1.60 = £1. US inflation is forecast at 5%, and UK inflation at 2% over the next year. Forecast the expected spot rate in one year, using PPP.

Answer:
Using the PPP formula:

S1=1.60×1+0.051+0.02=1.60×1.0294=$1.647=£1S_1 = 1.60 \times \frac{1 + 0.05}{1 + 0.02} = 1.60 \times 1.0294 = \$1.647 = £1

The USD is expected to depreciate as US inflation is higher than the UK.

Limitations and Practical Issues

PPP is a foundational theory, but is not always reliable as a forecasting tool in the short term due to:

  • Speculative capital flows, which may overwhelm trade flows
  • Government intervention in currency markets or controls
  • Non-traded goods and services, which affect measured price levels but not exchange rates
  • Transportation costs and trade barriers
  • The use of incorrect or estimated inflation forecasts

Worked Example 1.2

Canadian inflation is expected at 3%. Eurozone inflation is 1%. The current spot rate is €0.70 = C$1. Forecast the spot rate in one year under PPP.

Answer:

S1=0.70×1.011.03=0.70×0.9806=€0.686=C$1S_1 = 0.70 \times \frac{1.01}{1.03} = 0.70 \times 0.9806 = €0.686 = C\$1

The Canadian dollar is forecast to depreciate against the euro.

Exam Warning

Do not assume PPP will correctly predict actual exchange rate changes in the short term. For ACCA FM, always state limitations and use PPP primarily as a guide for long-term trends, not precise prediction.

PPP and Other Parity Conditions

PPP connects to broader parity concepts in finance:

  • Interest rate parity (IRP) links interest rate differences to forward exchange rates.
  • The Fisher effect connects nominal interest rates and expected inflation.

Understanding PPP helps in justifying the rationale behind other parity relationships tested in the exam.

Worked Example 1.3

Inflation in Brazil is projected to be 7%, while inflation in Japan is 1%. The current rate is ¥20 = R$1. What is the expected spot rate in one year?

Answer:

S1=20×1.011.07=20×0.944=¥18.88=R$1S_1 = 20 \times \frac{1.01}{1.07} = 20 \times 0.944 = ¥18.88 = R\$1

The Brazilian real is expected to depreciate against the yen.

Summary

PPP theory states that currency exchange rates should shift to offset price level changes arising from relative inflation rates. Higher relative inflation leads to expected depreciation, with the PPP formula providing a method for forecasting future spot rates. In practice, multiple factors disrupt this relationship, so PPP is best suited for long-term directional forecasting and understanding the link between exchange rates and inflation.

Key Point Checklist

This article has covered the following key knowledge points:

  • Define purchasing power parity (PPP) and parity condition
  • State and apply the PPP forecasting formula
  • Explain the effect of inflation differentials on exchange rates
  • Perform exchange rate forecasts using PPP
  • Identify limitations and practical complications of PPP in real-world forecasting

Key Terms and Concepts

  • purchasing power parity (PPP)
  • parity condition
  • spot rate
  • base currency

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