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PPP and the Real Exchange Rate
The real exchange rate is a function of the price or inflation differential and the nominal exchange rate. The relationship between the concept of PPP and the “real exchange rate” — or the nominal exchange rate adjusted for price differentials — is of necessity a close and important one. In line with this relationship is the core idea that if PPP is seen to hold over the long term, then the real exchange rate should remain constant. This is the case because if PPP holds relative price differentials between two countries will over the long term be offset by an appropriate nominal exchange rate adjustment. Granted, the real exchange rate may fluctuate significantly over the short term, with the result that such fluctuations can have potentially important economic impact, however, it should revert to mean over time assuming PPP holds. When the real exchange rate is constant, the international price competitiveness of a country’s tradable goods is maintained. Another way of expressing this is to say that when a country experiences high inflation, its tradable goods become proportionally uncompetitive. In order to restore price competitiveness, there has to be a depreciation of the nominal exchange rate. In order to gain competitiveness, a country needs a real depreciation, not simply depreciation in the nominal value of the exchange rate.
The behaviour of the real exchange rate and its components can be broken down into that existing under fixed and floating exchange rate regimes. Under a fixed exchange rate regime, the nominal exchange rate’s ability to move is of necessity limited, hence changes in the real exchange rate must be a direct function of the change in the inflation differential, and this is indeed what we find empirically. By contrast, under a floating exchange rate regime, both the nominal exchange rate and the inflation differential can change or “adjust” in economists’ jargon. Thus, the relationship between the real and the nominal exchange rates is considerably closer. Indeed, because inflation differentials adjust relatively slowly in floating exchange rate regimes, most of the adjustment to the real exchange rate comes from an adjustment in the nominal exchange rate. Hence, the same cautions of applying PPP to nominal exchange rate valuation should also apply to real exchange rate techniques.
To summarize this concept of PPP or the law of one price, it is a poor predictor of short-term exchange rate moves. However, it is considerably more accurate on a multi-month or multi-year basis. Note that in the case of the Euro–dollar forecasts, the 13% overvaluation noted in January 1999 and the 11% undervaluation noted in April 2001 was a multi-month guide to the future nominal exchange rate. Thus, a corporate Treasury department or a long-term strategic investor can find a PPP model highly useful in terms of providing a directional framework for medium- to long-term currency forecasting. A “macro” hedge fund or leveraged investor might also find this highly useful for spotting disparities between fundamental valuation and market perception. On the other hand, this is clearly less so for short-term traders whose perspective is measured in days or weeks.
Some final points to note with regard to PPP:
PPP provides a useful medium- to long-term perspective of currency valuation
If PPP holds, the real exchange rate remains stable over the long term
There can however be substantial short-term divergences from PPP
PPP may thus be particularly useful in currency forecasting for corporations, long-term investors and also leveraged investors, but much less so for short-term traders -
PPP and Corporate Pricing Strategy
The law of one price assumes the exchange rate will move over time so that the price of the same good is the same everywhere. However, corporations do not necessarily follow this as they may vary national prices of the same good to reflect a variety of factors in those countries such as local supply/demand dynamics, delivery costs, cultural tastes, customer price tolerance, target margin, competitor prices, market share considerations and so forth. To an economist, such price variations represent temporary distortions, which should over time be eliminated by market efficiency. To a corporate executive, faced with the frequently competing real-world priorities of profit maximization and raising market share, there may be nothing temporary about such “distortions”. As a result, PPP may in some cases not hold over the “short term” for homogeneous goods since such pricing strategies may not allow it to hold.