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Eureka: PPP Puzzle Eureka: PPP Puzzle
by Akli Hadid
2017-11-29 08:30:23
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The PPP puzzle has it that currency exchange rates are more volatile and fluctuate more than they should. The puzzle seeks to understand how nominal rigidity, that is how price control, could lead to more stable exchange rates.

ppp01_400I'll comment on this puzzle by using a few analogies. Let's imagine that I'm Joe and I sell beer and pizza. I get paid in Joe Dollars for that, 2 Joe bucks a pint of beer, 10 Joe bucks a pan of pizza. Then my neighbor Jim sells coffee, milkshakes and burgers. 10 Jim bucks a pound of coffee, 2 Jim Bucks and milkshake and 5 Jim bucks a burger.

Jim and Joe engage in two types of trade. Jim buys Joe's pizzas, Joe buys Jim's coffee. But occasionally, Jim and Joe trade each other's currency. Why do they trade each other's currency? First so Jim can buy Joe's stuff and Joe and buy Jim's stuff. Second as a safety net, let's say Jim and Joe save each other's currency. Third for speculation purposes, let say Jim thinks if he runs out of business he can have some reserves in Joe's currency and he'll be able to feed on beer and pizza for a bit.

Now let's imagine Joe engages in money creation. Let's say Joe traditionally has about 2,000 Joe dollars at any given time, but creates something like 30,000 Joe dollars. He goes to Jim and trades 1,000 Jim dollars for 1,000 Joe dollars. Jim hesitates, but goes, oh well, there you go. Jim doesn't want to know where Joe got all his money from or why he would want to exchange such a large sum of money. Now a few days later, Joe goes to Jim and wants to trade 2,000 Joe dollars for 2,000 Jim dollars. Wait a second wise guy, at this rate I might get ruined. Where did you get all that money from. Jim investigates and finds out that Joe created 30,000 Joe dollars out of thin air. OK Joe, I'll trade you 1 for 10. 1 Jim dollars for 10 Joe dollars, take it or leave it. Now you understand currency fluctuations.

 

Now let's imagine another case. Let's rewind for a second and imagine Joe never created those 30,000 Joe dollars. Let's say Jim and Joe occasionally borrow or loan money to each other, or get loans from third parties. Now let's say Joe wants to get a really nice pizza parlor and wants to try his luck with this whole craft beer thing. Let's say Joe borrows 10,000 Jim dollars from Jim and that he converts that loan into Joe dollars. That is Joe takes 10,000 Joe dollars from Jim, that Jim had stacked in his savings account. Let's say this craft beer thing doesn't work out as planned, and Joe finds no alternative other than to create 30,000 Joe dollars so he can keep up with the interest rates. Jim tells Joe, give me 50,000 Joe dollars and we'll call it even. Now Joe has to increase pizza and beer prices to the point they become unaffordable just so he can pay Jim back, and you get something like 5,000 Joe bucks a beer and 10,000 Joe bucks a pizza. Jim keeps demanding more Joe bucks to pay back the initial 10,000 Joe dollar loan, and you get the idea of inflation and currency devaluation.

 

Now let's look at the final option. Jim and Joe decide to list their businesses in the stock market, just like governments issue bonds for sale. Let's rewind and say Joe never got that loan in the first place. Let's say Joe collects 10,000 Joe dollars from the stock market, and let's say he tries this craft beer and cream cheese pizza thing and the whole thing doesn't work. That means 10,000 Joe dollars are now worthless. When Joe goes pay Jim in Joe dollars, Jim reminds Joe he got 10,000 Joe bucks and made nothing of them. Jim now asks 10 Joe bucks for each Jim buck.

 

Hope this gives you an idea of how currency works. Now imagine both Joe and Jim had very well functioning businesses with a lot of clients every day all day. That's when their currencies would stabilize, and all the loans and bonds would not have significant meaning in the way they traded currency. They could use some tricks though, such as hiding some of their money to overvalue their currency, but hiding the money would also mean the wife and kids would have to live modestly and so on. 


      
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