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Exchange rates and purchasing power parities
Exchange rate movements can be dramatic, as illustrated once again by the euro's rapid slide against other major currencies since the start of the summer. Such short- and medium-term movements are often driven by technical factors, particularly the positioning of market participants, rather than by macroeconomic fundamentals. At longer horizons, what can we learn from fundamental relationships such as the purchasing power parity (PPP)?
The concept of PPP
The PPP concept, which has been attributed to the 16th-century Salamanca School, is based on the assumption that exchange rates adjust to equalise the purchasing power in different countries. In other words, consumers should have no advantage in making purchases in one country rather than another because, after taking into account exchange rates, the cost would be the same everywhere. If this were not the case, the logic behind PPP suggests that residents of a country where consumer goods are more expensive would exchange their currency to buy goods in countries where the same goods are cheaper and then import them into their own country. In doing so, they would drive down the value of their currency (since they would have to sell it to buy foreign currency), up to the point where the transaction was no longer profitable. Indeed, depreciation would mechanically make foreign goods more expensive than their domestic counterparts. In its simplest form, this logic applies to tradable goods and services and ignores transport costs and other types of frictions. In practice, calculating PPP is more complicated. The series shown on the graph below is based on the PPP figures published by the OECD for the euro against the US dollar (measured in dollars per euro).
Sources: OECD, Macrobond, BGL BNP Paribas
Trends in PPP
A key factor in PPP movements over time is the difference in inflation rates between countries. Taking the example of the PPP of the euro against the dollar, there has been a gradual upward trend in PPP since the introduction of the single currency on 1 January 1999 (see graph). This reflects the fact that inflation was higher in the USA than in the eurozone. Over time, therefore, consumer prices in the USA (measured in dollars) increased faster than those in the eurozone (measured in euros). In other words, the theoretical exchange rate at which the purchasing power of American consumers would equal that of their eurozone counterparts increased.
Exchange rate volatility, smooth evolution of PPP
Empirically, PPP has a hard time explaining short- or medium-term exchange rate movements. The graph shows that PPP changes gradually over time, while market exchange rates are much more volatile. Exchange rates can diverge very substantially from PPP, as has been the case for the EUR/USD exchange rate since the euro was launched in 1999. During the years following the introduction of the common currency, the euro traded well below the value suggested by PPP. The situation reversed in 2003 and since then the euro has typically traded above the value suggested by PPP. In 2008, this gap reached levels close to 30%.
Recent depreciation of the euro
PPP is also helpful in interpreting the recent evolution of the euro exchange rate, which has depreciated sharply against other major currencies in the last few months. It has weakened in particular against the dollar, falling from a peak around 1.39 in May to less than 1.29 in September. Even though this movement was triggered by other factors, including the increasingly apparent divergence between the monetary policies of the Federal Reserve and the European Central Bank, its effect has been to bring the exchange rate closer into line with PPP, which the OECD estimated to be around 1.29 for 2013.
PPP can be interpreted as a mean-reverting force in the long run although it is clearly not a reliable indicator of currency movements in the short or medium term. In particular, it does not predict whether the forces behind the euro's recent depreciation will continue to be at work in the months ahead.
BGL BNP Paribas
Published in the Luxemburger Wort (in French) on 25 September 2014