Purchasing Power Parity as a Measure to Determine Exchange Rate - Essay Example

Purchasing Power Parity (PPP) As A Measure To Determine Exchange Rate (Name of Student) (Name of Professor) (Class Number) (Course) Date Table of Content Executive Summary 3 Introduction to Purchasing Power Parity (PPP) 4 The Consumer Price Index (CPI) and PPP 4 PPP as a Theory of Exchange Rate Determination 5 Problems and Extensions of PPP 5 Problems with the PPP Theory 5 Relative PPP theory 6 PPP in the Long-Run 7 Overvaluation and Undervaluation 7 Over (Under) Valuation with respect to PPP 7 Over (Under) Valuation with respect to Current Account Balance 8 PPP and Cross-Country Comparisons 8 Conclusion 9 References 10 Executive Summary The Theory of Purchasing Power Parity is used by economist as one way to determine the level of exchange rate between and among countries. It states that exchange rates adjust as prices of goods and services between countries change until it reaches an equilibrium level. However, there are many factors that made the use of PPP as determinant of exchange rate difficult to apply in the real market due to the limiting assumptions it holds like absence of transportation costs and absence of barriers to trade which very much exist in the current market with the imposition of various trade restrictions across countries. Given this limitation, PPP is still being used by reputed organizations to compare and rank levels of GDP across countries. Introduction to Purchasing Power Parity (PPP) Gustav Cassel developed the Theory of Purchasing Power Parity, commonly known as PPP, in 1920 (Wikipedia). It is a theory that determines exchange rate between two countries’ currencies. It holds that adjustments in these exchange rates happen as changes in the levels of prices of goods and services in two countries involved (Mishkin 1998). It further assumes that “the actions of importers and exporters, motivated by cross country price differences, induce changes in the sport exchange rate” (Suranovic, 1999). In practice, PPP is a rate that converts into a common rate of currency that even out various currencies purchasing power eliminating the variance of the levels of prices of two countries (OECD). The theory of PPP is a simple implementation of the Law of One Price (LoOP) which states that a uniform international price for the same good produced by two countries (Mishkin, 1998). Relating it to the value of exchange rate, PPP is therefore the implementation of a uniform price for a certain good relative to exchange rate of one currency to the other. For example, the price of a computer in Euro must equal to its price in US Dollars. Thus, any increase in price of the computer in Euro will redound to an appreciation of the price in US Dollars and vice versa. Using PPP to determine exchange rates lessens the adverse effects of volatility of a country’s currency particularly in calculating gross domestic product (GDP). It is particularly useful on this aspect in temporary devaluation of certain currencies due to internationally related trade issues. Thus, in the long run currencies reach its equilibrium rate. The Consumer Price Index (CPI) and PPP CPI measures the average prices of goods and services in a given period comparing it to a base period. These goods and services are basic to the needs of household consumers. It reflects how high or low is the inflation level of a certain country compared to a base year. CPI is somewhat related to the calculation of PPP if two countries bear the same base year in calculating CPI (Suranovic, 1999). Thus, it is only relevant to the derivation of PPP is the same base year is used between two countries. PPP as a Theory of Exchange Rate Determination “The PPP relationship becomes a theory of exchange rate determination by introducing assumptions about the behavior of importers and exporters in response to changes in the relative costs of national market baskets’ (Suranovic, 1999). A market basket here refers to various goods and services in an economy of a country. As the law of one price states that in the long run prices of goods and services reach equilibrium as market players like importers and exporters moves within the market to sell and purchase goods and services which also applies to currency movement or exchange rates between two countries. Equilibrium in PPP is actually the equalization of exchange rates between two currencies. Arbitrage or the process of trying to earn profit through exploiting price differences of goods and services will eventually affect the level of exchange rates until it reached equilibrium as a result of changes in supply and demand for foreign exchange between exporters and importers to purchases goods and services across countries. The increases or decreases in prices of goods in one country can lead its currency to either appreciate or depreciate resulting to a reverse effect to the exchange rate of another country that is trading with the former. Problems and Extensions of PPP Problems with the Theory of PPP Baskets of goods vary across countries which makes it difficult to reach a uniform level of price which makes it complicated to estimate PPP levels for each country. Also, each country consume varied group of goods and services which makes the pattern of purchasing variable across countries (Wikipedia). Other problems related to the use of PPP in exchange rate determination include the following: (1) it does not reflect the realistic difference of the quality of goods consumed in each country, (2) each region or zone of currency like that for euro and dollar has high variance, (3) market exchange rate is usually used in the purchase of imported goods, and (4) there is no known uniform global market hence equilibrium is a far fetch for the international market. It is for these reasons that PPP is viewed as not a perfect measurement to illustrate the standard of living across countries (Wikipedia). Suranovic (1999) specifically cited reasons why PPP is not possible in his electronic book entitled International Finance Theory and Policy. These economic reasons are (1) costs of transportation and restrictions on trade, (2) costs of the so called “non-tradable inputs”, (3) perfection in information, and (4) other market participants. The LoOP where PPP is derived assumes that there are no transportation costs and trade restrictions in trade actions across two countries which is not applicable in real world since there are trade barriers and subsequent transportation costs applied by economic regions or countries with regards to import and export of goods and services. Inputs that are non-tradable but affect prices of goods and services such as space rentals varied across locations which subsequently affect the prices of the same product across locations particularly for franchise foods. Information with regards to trade are sometimes not perfect in the real market to protect interests of producers or traders which go against the assumption of LoOP which assumes perfect information in markets. Other market participants apart from exporters and importers such as investors have an impact on the changes in exchange rates given the volume of investments that requires foreign exchange transactions. Extension of PPP-The Relative PPP Theory The Relative PPP Theory is another option to PPP Theory. It assumes that differences in exchange rate are dependent on differences in inflation rate across countries which are not directly assumed by the PPP Theory, though it suggests it (Suranovic, 1999). That is why if Country A’s inflation rate is higher than Country B, the latter’s currency will appreciate. PPP in the Long-Run Given the points discussed above, PPP in the long run will hold true since eventually market actions will force differences in market prices and exchange rates to equalize; hence reaching an equilibrium exchange rate. The role of arbitrage will lead the market to equalize since individuals or companies or industries will find ways to pull down prices of goods and services to earn profit thereby accordingly affecting the level of exchange rate in the long run (About.Com). It is for this reason that economists are reluctant to do away with the PPP theory since it does not hold true in the short run (Suranovic, 2006). Overvaluation and Undervaluation Exchange rate of a country can be overvalued or undervalued relative to PPP and overvalued or overvalued relative to the balance of current accounts. The possibility of these scenarios is discussed below. Over (Under) Valuation with respect to PPP Overvaluation of a Country A’s exchange rate versus Country B’s exchange rate with respect to PPP means that the prices of goods and services in the former is expensive compared to the latter. Consequently, Country A’s currency can buy more goods when used in purchasing goods in Country B using current spot exchange rate. Undervaluation of Country A’s exchange rate compared to Country B’s exchange rate is the opposite of the example provided above. Thus, prices of goods in Country A is cheaper compared to the prices of goods in Country B making it expensive to purchase goods from the latter using the current exchange rate. Further, it implies that the former’s currency can buy lesser amount of goods at Country B. Using the interplay of the currencies between two countries, when Country A’s currency is overvalued it consequently makes Country B’s currency undervalued and vice versa. Over (Under) Valuation with respect to Current Account Balance Changes in exchange rates affect the flow of trade or current account balance in an economy. When Country A experience trade deficit by higher import or lesser export, it can balance its trade depreciating its currency since it is overvalued. Consequently when its currency is undervalued, it works to appreciate its currency to achieve current account balance by eliminating a trade surplus. However, cautions are given in relying in exchange rate to correct trade imbalance since there are other factors that affect its occurrence (Suranovic, 2006. Various factors related to trading and financial aspects impact on the level of current account balance of certain country hence estimations on how to correct the value of certain currencies to reach a trade balance must be assessed carefully. PPP and Cross-Country Comparisons PPP exchange rate’s application across countries can be presented through the use of Gross Domestic Product (GDP) data. The following Table presented by Suranovic (2006) shows a cross country comparison of GDP rankings in the year 2004 based on data from World Bank using the PPP exchanges in comparison with the current exchange rate for that year. The result showed that there are certain countries like China, India and Russia that produced more goods and services using the PPP exchange rate compared to measuring GDP using the current exchange rate. It implies that a true picture of one’s economic production is seen through the use of PPP exchange rate. Further, currencies of countries that rise in ranking like China, India and Russia when their currencies were converted using PPP were undervalued relative to the dollar using the current exchange rate; hence measurement of its economy is underestimated. Consequently, currencies of countries that fell off in GDP ranking when its exchange rate was converted using PPP like Germany, UK and Canada are overvalued when it was measured using current exchange rate. GDP Rankings 2004 (billions of $) Rank Using current exchange rate Using PPP exchange rate 1 US $ 11,667 US $ 11,628 2 Japan $ 4,623 China $ 7,124 3 Germany $ 2,714 Japan $ 3,774 4 UK $ 2,140 India $ 3,362 5 France $ 2,002 Germany $ 2,326 6 Italy $ 1,672 UK $ 1,832 7 China $ 1,649 France $ 1,744 8 Spain $ 991 Italy $ 1,621 9 Canada $ 980 Brazil $ 1,483 10 India $ 692 Russia $ 1,408 Source: Table Constructed from World Bank Data as Presented in International Finance Theory and Policy by Steven M. Suranovic (2006). The above presentation showed the relevance of PPP when comparing performance of various countries levels of GDP. It realistically show how productive each country is compared to other countries. The example above showed that developing economies like China and India have higher levels of production compared to other developed economies like Japan and UK. Such findings is relevant since it also led to the analysis that developed countries must be possibly outsourcing its production in developing countries hence the resulting decrease in its ranking. In essence, the presentation also led to the analysis of the interrelationship of productions of developed and developing economies. Conclusion Using PPP to determine exchange rate of currencies helps show the true size or at least the true level of production of goods and services of a country’s economy as shown in the table comparing the difference in GDP of countries using current exchange rate and PPP exchange rate. However, adapting PPP as a measure to determine exchange rate applied in a market transaction, meaning in the actual interplay of market players, is difficult due to varied factors that are working in a real market and due to limitations of the assumptions of PPP as discussed in the section on problems with PPP as a measure of exchange rate. PPP with its limitation still cannot be disposed since in the long run exchange rate will eventually reach its equilibrium level as market forces or arbitrage in the real market progress. Eventually, PPP will hold true in the long run. Also, given its limitation, respected international economic organizations like the World Bank and Organization for Economic Cooperation and Development (OECD) are using PPP exchange rate to measure the actual size of one’s economy in terms of production of goods and services. This only shows that PPP is still considered economically relevant today. References Wikipedia, The Free Encyclopedia. Purchasing Power Parity. Retrieved on 4 November 2007 from Mishkin, F. S (1998). The Economics of Money, Banking and Financial Markets. Addison-Wesley Longman, Inc. Reading, Massachusetts. Suranovic, S.N. (1999). International Finance Theory and Policy. Retrieved on 03 November 2007 from Suranovic, S.N. (2006). International Finance Theory and Policy. Retrieved on 03 November 2007 from Organization for Economic Cooperation and Development (OECD). Purchasing Power Parities. Retrieved on 03 November 2007 from About.Com: Economics. Retrieved on 04 November 2007 from Read More