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The Beer Standard

There are very few McDonald`s branches in Africa, so we can`t use Big Macs to test the law of one price there. But barley beer is a common and relatively homogeneous product throughout Africa. So we can test the law of one price using the beer standard.

Table 6.7 shows the price of a bottle of beer in several African countries expressed in local currencies and converted into South African rand using the spot exchange rate. For example, beer in Kenya cost 41.25 shillings; at an exchange rate of 10.27 Kenyan shillings per rand, this is equivalent to a price of 41.25/10.27 = 4.02 rand. This is 1.75 times the cost of beer in South Africa; for the costs to be equal, the shilling would need to depreciate by 75 percent to a new exchange rate of 10.27 ГЧ 1.75 = 17.9 shillings per rand. Therefore, we might say that this comparison suggests the shilling is 75 percent overvalued against the rand.

A weaker version of the law of one price is known as purchasing power parity, or PPP. PPP states that although some goods may cost different amounts in different countries, the general cost of living should be the same in any two countries.

Purchasing power parity implies that the relative costs of living in two countries will not be affected by differences in their inflation rates. Instead, the different inflation rates in local currencies will be offset by changes in the exchange rate between the two currencies.

For example, between 1993 and 1998 Russia experienced high inflation. Each year the purchasing power of the ruble declined by nearly 35 percent compared with other countries` currencies. As prices in Russia increased, Russian exporters would have found it impossible to sell their goods if the exchange rate had not also changed. But, of course, the exchange rate did adjust. In fact each year the ruble bought over 33 percent less foreign currency than before. Thus a 35 percent annual decline in purchasing power was offset by a 33 percent decline in the value of the Russian currency.

In Figure 6.2 we have plotted the relative change in purchasing power for a sample of countries against the change in the exchange rate. Russia is toward the bottom left hand corner; the United States is closer to the top right. You can see that although the relationship is far from exact, large differences in inflation rates are generally accompanied by an offsetting change in the exchange rate. In fact, if you have to make a long term forecast of the exchange rate, it is very difficult to do much better than to assume that it will offset the effect of any differences in the inflation rates.

If purchasing power parity holds, then your forecast of the difference in inflation rates is also your best forecast of the change in the spot rate of exchange. Thus the expected difference between inflation rates in Mexico and the United States is given by the right-hand boxes in Figure 6.1:

For example, if inflation is 2 percent in the United States and 20 percent in Mexico, then purchasing power parity implies that the expected spot rate for the peso at the end of the year is peso11.10/$:

Current ГЧ expected difference = expected spot rate spot rate in inflation rates 9.438 ГЧ 1.20 = 11.10

PURCHASING POWER PARITY (PPP) Theory that the cost of living in different countries is equal, and exchange rates adjust to offset inflation differentials across countries.