The Theory of Purchasing Power Parity - Assignment Example

Discuss the theory of purchasing power parity, by considering its various forms and examining critically its assumptions and the empirical evidence for and against it. Introduction The key proponent of the PPP theory is Gustav Cassel who developed the theory in 1920. The Purchasing Power Parity refers to a theory of economics, which is used to estimate the adjustment that should be applied on the rate of exchange between nations. The main aim of using the theory to estimate the equilibrium emanates from the desire to ensure harmonisation in the exchange, as well as meet the purchasing power of each of the countries. The rate of exchange between two currencies can be termed as equilibrium when there is an equivalence in the purchasing powers of these countries at the domestic level (Taylor & Taylor 2004, p. 135). The theory of Purchasing Power Parity The formula for calculating purchasing power parity is as follows: S=P1/P2, where S refers to the rate used to exchange currency one with currency two, P1 is the price that good “x” costs when purchased in currency 1, and P2 is the price at which good “x” sells when purchased in currency 1. Based on the Purchasing Power Parity, there is an adjustment in the exchange rate in order to ensure that similar goods in two countries can be bought at the same price when the same currency is used to express the value of the good. There tends to be various forms that the Purchasing Power Parity takes. Some of the most common forms that this theory takes include the absolute Purchasing Power Parity and the Relative Purchasing Power Parity (Apte et. al., 2001). The concept of Absolute Purchasing Power Parity holds that the rate of currency exchange between two countries remains the same as the price level ratio in these countries. The absolute PPP borrows from the law of one price. Based on one price law, the cost of a certain product should remain constant across several countries. The similarity in price should be in accordance to the currency value in the economies of both countries. This should take consideration of all other prices, such as trade regulations and other factors affecting market demand and supply, which should remain the same between these countries. The absolute Purchasing Power Parity also holds that there the purchasing power of the foreign and the domestic policy should remain the same. This means that there should be no variation in price when a consumer wants to exchange a foreign currency for a domestic currency, or a domestic currency for a foreign currency (Almås 2012, p. 1093). In order to meet the premises for the absolute Purchasing Power Parity, several conditions have to be fulfilled. One condition that must be met is free trade of the goods from each country in the international market. The other condition is that there ought to be a compromise of the price index of the price index for each of the two countries, which will be involved in the exchange of goods. Absolute PPP can result from the differences that exist in weighing, regardless of the fact that the law of one price can hold for certain goods across nations. While determining the absolute purchasing power parity, there is a tendency to examine the changes taking place in the level of the prices, which can be calculated easily (Apte et. al., 2001). Relative purchasing power parity can also be regarded as another form that the theory of PPP takes. Relative PPP focuses on the changes in the inflation rates, which may be anticipated, in relation to changes in the exchange rates between countries. The relative purchasing power parity explores the change and variations in prices that take place between two countries. Relative PPP posits that there tends to be a change in the exchange rates in order to ensure that the variations and differentials, which inflation causes, can be compensated for and covered (Almås 2012, p. 1097). In the relative purchasing power parity, the formula that explains the relationship is as follows: S1/S0= (1 + Iy) ÷ (1 + Ix). S0 represents the exchange rate when the period begins and can be expressed as the "y" country price of one unit of currency x. S1 stands for the rate of exchange when the period comes to an end. Iy refers to the rate of inflation that is anticipated annually for the foreign country, which is represented by y. Ix stands for the rate of inflation that is expected annually for the domestic country (country x). The basis of Relative PPP is that the variations between the inflations rates of two countries, expressed as a percentage, is similar to the depreciation and appreciation percentage differences between the two countries. Therefore, although there may be variation in the price of an item between two countries, the differences in the percentage may not change for a long period (Taylor & Taylor 2004, p. 137). Apart from the absolute and relative PPP, the theory of purchasing power parity may also take the form of interest rate PPP. The interest rate PPP distinguishes between forward rate and spot rate. Forward rates entail a scenario where investors specify an exchange rate of a currency with the expectation that, in the future, they will implement what they have planned. On the other hand, the spot rate refers to the current rate of exchange of currencies. According to the interest rate PPP, the differences in percentages between the spot rate and exchange rate are the same as the percentage differences in the rates of interest between the two countries (Alba & Papell 2005, p. 4). The PPP assumes that people demand foreign currency since it possesses purchasing power in its country. People demand the domestic currency because of the purchasing power attached to it as the domestic currency can be used while buying goods in the domestic or local markets. The theory also makes an assumption that when there is an exchange of the foreign currency with the domestic currency, this can be referred as the exchange of the domestic purchasing with the purchasing power (Islam & Ahmed 1999, p. 1). The PPP theory suggests that the real exchange rates ought to be stationary. When the real exchange rates are stationary, appreciation or depreciation tends to offset any changes in the percentages of price levels. The theory determines whether there is a shift in exchange rates when there are changes in the relative prices. The purchasing power parity theory can be used in the calculation of the GNI per capita. The GNI of PPP details the conversion of GNI to the main currency of exchange (mostly the dollar) with regard to the rates of the purchasing power parity (Coackley et. al., 2005). The PPP has been instrumental when it comes to estimations; for example, the theory has been used to determine the movement of exchange rates and why these rates tend to follow a certain direction. Normally, nations having high inflation rates have their currency depreciating for some time. On the other hand, the currency of countries having lower rates of inflation tends to appreciate in value, unlike the countries with high rates of inflation. PPP has also been extremely instrumental in determining whether global prices exhibit competitiveness. When the currency of a country depreciates, the prices of the goods produced in the country will become cheap, and this will make the country more competitive than its trading partners. When the currency appreciates in value, the opposite happens (MacDonald & Ricci 2002, p. 5). Based on the PPP theory, the exchange of the home or domestic currency with a foreign currency can be regarded as the exchange of the purchasing parity from the domestic level to the purchasing parity at the foreign level. The PPP theory also holds that the exchange rates reflect the change in the purchasing power, which may be witnessed in either of the currencies. Thus, under the theory of purchasing power parity, the external value that can be attributed to a certain currency borrows a lot from the purchasing power of that currency at the domestic level with regard to the purchasing power of another currency (MacDonald & Ricci 2002, p. 6). The law of one price that guides the main assumptions in the theory holds there should be an equalization of prices by competitive markets provided that the commodity being exchanged is identical. This happens when the goods have been exempted to expenses such as transaction cost, cost of transportation, as well as other costs. The law of one price applied under several situations; one situation is that barriers to trade, costs of transactions and transportation have to be excluded. The other condition is that the markets should be competitive enough to allow the smooth flow and movement of goods, as well as services, between these two countries (Islam & Ahmed 1999, p. 2). A critical assessment of the assumption of law of one price indicates that the purchasing power parity theory may not hold. The theory can be faulted on the basis that it may not be possible to avoid some costs such as transportation costs and transactions costs. In the exchange of goods and services between countries, some costs have to be incurred such as taxes, duty, and some costs that emanate from tariffs. Incurring such costs violates the law of one price and renders some of the assumption by the theory irrelevant. In addition, the law of one price may not be applicable between countries since not all countries engage in the trade, or exchange of similar goods. Rather than basing purchasing power parity on the law of the price, it would be appropriate to test the assumptions of the theory with price indexes of the producers. The international goods arbitrage also contradicts the assumptions of the purchasing power parity theory (Alba & Papell 2005, p. 6). A notable assumption of the purchasing power parity theory is that both the countries involved in the exchange of goods, as well as currencies, deal with similar goods, or commodities that belong to similar groups. Such an assumption may not hold since international trade focuses on specialisation, which acts as the basis of production. In addition, the assumption of change in price can be regarded as theoretically unclear. There is no uniformity in the prices of all commodities since there may be certain changes, which may emanate from the market conditions. As such, there are some commodities whose prices may decrease or increase more frequently than the price of other commodities. On this regard, therefore, it may not be feasible to make comparisons with regard to the movement in prices that may be witnessed in both countries (Rogoff 1996, p. 647). The arguments in favour of the purchasing power parity theory focus on the various strengths of the theory. One of the arguments in favour of the PPP theory is that the exchange rates proposed by the theory may become stable for some time. On the contrary, market rates may vary in accordance to the volatility of the market, and they may bring large variations in the measures used to measure aggregate growth. The purchasing power parity theory can also be credited since it applies for both international and local goods. This contrast market based rates, which can only be employed when dealing with goods traded in international markets. Another argument in favour of PPP theory is that theory is instrumental in measuring the quality of life between countries. This is because knowledge of the differences in purchasing power helps to determine the living standards between two countries (Coackley et. al. 2005, p. 295). The PPP theory has also been hailed because of its ability to determine the gross domestic product; thus, the theory helps in measuring the wealth of countries. The purchasing power parity theory is also instrumental as it helps in correcting the trade imbalances, which may exist between countries. Based on this theory, trade imbalances can be solved through the adjustment of the currency with the main aim of harmonising the purchasing power. Moreover, the theory has been favoured by economists and trade analysts since it strives to account for the relationship that exists between the rates of exchange and the level of prices in the domestic arena. The theory’s explanation of a country’s balance of payment can also be considered as strength of the theory (Sekioua & Karanasos 2006, p. 200). Despite the several arguments in favour of the theory, some critics have discredited the theory based on some of the assumptions that the theory makes. One of the arguments against the theory is that it discards the approach of both supply and demand. This is because the theory does not explain the supply and the demand of foreign currency. Thus, the theory is inadequate since it does not focus on demand and supply that may have a far-reaching impact on demand and supply of domestic and foreign currencies. Another criticism of the theory borrows from the assumption that the exchange rate happens smoothly and that there are no controls that may hinder free trade. However, this may not be the case since countries may intervene and hinder the free flow of goods since there may be some restrictions with regard to licensing of imports, as well as duties levied on exports and imports (Taylor 2001, p. 476). Critics have also pointed out that some of the assumptions that the theory makes are invalid and cannot be applicable in a hypothetical situation. For example, the theory does not take into account international flow of capital, which may influence the foreign exchange market. The theory also fails when it comes to forecasting of the exchange rates at the equilibrium level. The PPP approach used to calculate the rate of exchange cannot predict the exchange rates at the equilibrium. The theory has a limitation since it does not take into account commodities, which may be in the balance of payments. This means that the theory may not cover transactions related to capital accounts, but only focuses on transactions that relate to current accounts. The theory can also be criticized for its explanations of the price index, which it employs in measuring the changes in the equilibrium exchange rate. Price indices may be affected by various factors, thus questioning their validity in determining equilibrium (Taylor 2001, p. 482). Conclusion In conclusion, the Purchasing Power Parity refers to a theory of economics used to estimate the adjustment on the rate of exchange between nations. The theory estimates the equilibrium emanates from the desire to ensure harmonisation in the exchange. Some of the most common forms that this theory takes include the absolute Purchasing Power Parity and the Relative Purchasing Power Parity. The purchasing power parity is based on the assumption that people demand foreign currency since it possesses purchasing power in its country. One of the arguments in favour of the PPP theory is that the exchange rates proposed by the theory may become stable for some time. Critics have also pointed out that some of the assumptions that the theory makes are invalid and cannot be applicable in a hypothetical situation. References List Alba, J. D. & Papell, D. H. (2005). Purchasing Power Parity and Country Characteristics: Evidence from Panel Data Tests, National Science Foundation 31 (57), pp. 1-20. Almås, I. (2012). International Income Inequality: Measuring PPP Bias by Estimating Engel Curves for Food, American Economic Review 102(2), pp. 1093-1117 Apte, P. et. al. (2001). The Exchange Rate and Purchasing Power Parity: Extending the Theory and Tests. [Online] Accessed 10 April 2013. Available at: http://www.london.edu/facultyandresearch/research/docs/ApteSercuUppal.pdf Coackley, J. Et. al. (2005). Purchasing power parity and the theory of general relativity; the first tests, Journal of International Money and Finance 24 (2), pp. 293-316. Islam, A. M. & Ahmed, S. M. (1999). The Purchasing Power Parity Relationship: Causality and Cointegration Tests Using Korea-U.S. Exchange Rate and Prices, Journal of Economic Development 24(2), pp. 1-17. MacDonald, R. & Ricci, L. (2002). Purchasing Power Parity and New Trade Theory, IMF Working Paper 02(32), pp. 1-34. Rogoff, K. (1996). The Purchasing Power Parity Puzzle, Journal of Economic Literature 34 (2), pp. 647-668 Sekioua, S. H. & Karanasos, M. (2006). The real exchange rate and the Purchasing Power Parity puzzle: further evidence, Applied Financial Economics 16(5), pp. 199-211 Taylor, A. M. & Taylor, M. P. (2004). The Purchasing Power Parity Debate, Journal of Economic Perspectives 18 (4), pp. 135-158. Taylor, A. M. (2001). Potential pitfalls for the purchasing power parity puzzle? Sampling and specification biases in mean-reversion tests of the law of one price, Econometrica 69(1), pp. 473-498. Read More