Power Purchase Parity Issues - Essay Example

Power Purchase Parity July 5, 2006 Purchase power parity is often used to describe the relationship of exchange rates between economic and national boundaries. This theorem relies heavily and implicitly on the concept of relative pricing. Exchange rates are, however, not only defined by the theory of relative pricing, but many other factors. This paper looks at the definitions of exchange rates and relative pricing as well as their relationship in purchase power parity to discover if the hypothesis of purchase power parity is true. The purchase power parity hypothesis is based on the law of one price, that the equilibrium of trade between boundaries is constant. The conclusion is that this is highly assumptive and neglects other possibilities that control the relative price and exchange rates. Economic Theory 4 Background 4 Exchange Rate 5 Relative Prices 6 Purchase Power Parity 8 Purchase Power Parity Assumptions 10 The Law of One Price Assumptions 11 Conclusions 13 References 17 Economic Theory Economists argue that the economic benefits of trade between nations in goods, services, and assets are similar to the benefits of trade within a nation. In both cases, trade in goods and services permits greater specialization and efficiency, whereas trade in assets allows financial investors to earn higher returns while providing funds for worthwhile capital projects. However, there is a primary difference between domestic versus international transactions; specifically, trade within a country normally involves a single currency, but trade between nations usually involves dealing in different currencies. There are also subtle and unavoidable concerns when establishing in purchase power parity that exchange rates are only controlled by relative pricing. This theory requires that stabilisation and equivocal trade are inherently continuous, and does not account for cost, policy and specialisation as substitution. Therefore, while purchase power parity holds in some cases, it can not be assumed (as it currently is) to hold in all cases. It will only hold under specific criterion, and not when there is fluctuations in real cost and trade. Background To understand the founding principles of purchase power parity, a first look at the underlying components of exchange rates and relative prices is necessary. Exchange rates are the cost of one good compared to the price of another across national borders. The exchange rate simply converts the GDPs (Gross Domestic Products) into the same currency units. Even when valued in the same currency unit, the ratios of GDPs in different countries still have to be split into their volume and price components. This is often believed to be controlled by the theory of relative prices, that one product has an equal value to another product in different countries. The law of one price is the founding principle of this theory, explained by the purchase power parity concept. Purchasing power parities (PPP) are rates of currency conversion constructed to account for cross-country variation in prices. The calculation of PPPs is based on pricing a representative basket of goods and services across countries, and weighing this basket with the expenditure patterns prevailing in each of the countries. The PPP conversion rate allows for volume comparisons, i.e. comparisons involving the level of health expenditures in real terms. Exchange Rate The foreign exchange is the act of trading money between nation, where the money takes the same form of the originating country, and monetary assets traded in foreign exchange markets are demand deposits in banks. The exchange rate is specifically the price of one country's money in terms of another country's money, and this is very dependent on the time-value of money (Hallword and McDonald 2000). Foreign exchange quotations are shown as a bid/offer rate. The dollar lies at the heart of foreign exchange dealing, as most transactions involve moving in and out of the dollar. Sterling and currencies which were linked to sterling quote so many dollars to the domestic currency. Other currencies quote a quantity of that currency to the dollar (Maslovic 2004). There are two basic fundamentals in the exchange rates. The spot exchange rate is the price for instant exchanges, usually occurring in one or two business days and through a bank. Spot rates are today's exchange rates with settlement in 2 days. (Pugel p 400 2003). The forward exchange rate is the price now for an exchange that will take place in the future. Forward rates are fixed rates for a transaction at a later date. This is basically trading on the time-value of money, where the price is agreed on based on the duration of the trade end, such as 30, 90, or 180 days from the time of initiation (Pugel p 400 2003). Spot rates are today's exchange rates with settlement in 2 days. Both rates are determined by the difference in interest rates in the two currencies concerned. Worldwide, 60% of deals by value are forward and 40% spot (Maslovic 2004). Any business person trading across borders has to concern themselves with differences in exchange rates. Most countries of the world have their own currency, and when the buyer of a product deals in a different currency than the seller, some exchange has to be made. Markets set exchange rates for most major currencies, but these market levels vary over time. The demand for foreign exchange arises from trade, tourism, government spending, international security trading and speculation. The foreign exchange market is huge, trading $1.9 trillion a day in 2004 with London the biggest market, and Interbank business in London is 53% of the market by value and the top ten banks dominate. Foreign exchange dealing accounts for half the profits of the big US commercial banks (Maslakovic 2004). Relative Prices Relative price is the foundation of exchange rates, where future price value of an output or input relative to the price of another input or output, or to the prices of all goods and services in general. Without trade, the prices of each country are determined only by the conditions of that country, but with trade between borders, relative price is the ratio of one product price to another product price (Pugel p 41 2003). Not only are the prices of individual goods and services different but there are systematic differences in price levels between countries. Price levels are usually lower in poorer countries. It is necessary to adjust for these price level differences to get at the volume comparisons. Companies or other agencies operating in several countries are interested in the relative price levels in those countries. Tourists and others traveling from one country to another are also very interested in the relative price levels, and therefore there is demand for the price indices as well as the volume indices. Countries produce products to meet demands at different price levels until the tendencies of normal trade create an equilibrium relative price, in its simplest form this is the worth of one product between two countries based on the strength of demand. This equilibrium international price ratio-relative price-will fall within the range of the two price ratios that prevailed in each country before trade began (Pugel p 42 2003). This two sided pricing theory measures the asymmetry in the relative price distribution. This has been critised as having generalised results that support the emphasis of aggregate elements lumped into heterogeneous microeconomic behavior (Ratfai 2004). If all prices increase at the same rate, all prices will rise but relative prices will remain unchanged. If the price of an output or input increases either more slowly or faster than the prices of other goods in general, then there will be a relative price change. This general equilibrium shows that trade affects the rates of pay in production inputs as well as commodity and quantity outputs (Hallword and McDonald 2000). This generalisation does not explain significant forecast error variance inflation in a financial year (Ratfai 2004). "While the contemporaneous correlation between inflation and relative price asymmetry is positive in monthly frequency data, idiosyncratic shocks lead to a substantial build up in inflation after two to five months following the initial disturbance" (Ratfai p 6 2004).Anything that changes the relative price of a product also changes the distribution of income within the nation, and as the price of one supply drops the economy moves towards another product, therefore the economy falters, jobs are lost, suppliers are divided, and there is a change in the product surplus until the equilibrium is established either by a change in the relative price, trade demand, or a change in the product supply (Pugel p 42 2003). "For that, both trade costs and imperfect competition with variable markups are essentialobserve that if firms set both domestic and export prices at a constant (but perhaps different) markup over marginal cost, then shocks to the marginal cost of production leave the ratio of export prices to producer prices in each country unchanged" (Atkeson and Burtstein p 4 2006). Purchase Power Parity One economic theory for explaining exchange rates is purchasing power parity (PPP). Pricing the same basket of goods in two countries should result in the exchange rate (Hallword and McDonald 2000).. If a country consistently has higher inflation than another, its currency will tend to weaken compared with that of the country with lower inflation. The high inflation country will have to offer higher interest rates to persuade non-nationals to hold its currency (Hallword and McDonald 2000).. PPP is prepared using relative prices for a very large number of comparable goods and services because the levels of price differences differ between different items and parts of the economy (Hallword and McDonald 2000). The process of preparing PPPs means that insufficient or poor quality data for some countries can affect the results for all countries and not just the PPPs for the country concerned. The representative products play a key role, and each country needs to have enough of its own representative products on the product list. Even if a country prices several items, if none are representative of its economy, that country would be excluded from the calculation of that particular PPP. The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries (Sarno and Taylor 2002). The assumption that the price of a commodity differs between any two levels of the marketing channel by no more than the transfer costs (Sarno and Taylor 2002). For example, by this law, the price is expected to differ between any two locations by no more than transportation costs. Implicit in this law is the assumption of extreme specialization and perfect substitution between domestic and foreign commodities. A law stating that the forces of competition will ensure that any given commodity will be sold at the same price; otherwise it will pay someone to buy where it is cheaper (thereby tending to raise price in that market) and sell where it is dearer (thereby tending to lower price in that market) (Sarno and Taylor 2002). The process ends only when the price is equalised in all markets. Allowance must, of course, be made for transport and transaction costs (Sarno and Taylor 2002). In order to have enough price ratios to enable robust estimates of the parities, countries have to collect prices for at least some products that are not representative of its economy. They have to collect prices for a mix of products, some of which are representative of their own country and others that are representative of other countries (Hallword and McDonald 2000). The standard theory implies that international relative prices are determined differently from national relative prices. In the national case, relative prices are regulated by real costs of production. But in the international case, relative prices are assumed to be determined by the degree of imbalance between exports and imports, and to move in such a way as to eliminate this imbalance (hence to make each nation equally competitive in international trade). This means that international relative prices cannot also be determined by costs of production (Shaikh 1984). Purchase Power Parity Assumptions The underlying assumption of PPP is that exchange rates are controlled by relative prices and that no other economic factor is applicable. This means that as product trade between countries continues, there would be an eventual and natural apex of the pricing structure that is only dependent on the trade, and this apex would become a plateau between the two countries, where the price of one product is equal to the price of another. This expansion forms the basis of the purchasing power parity (PPP), where the law has received much of its empirical testing. Taylor and Taylor (2004, p.137) state "[T]he Law of One Price, [abstracting from, or ignoring transport cost] implies that a PPP exchange rate should hold between the countries concerned." Another extension that can further expand the domain of the law is in combining two or more of its applications. For instance, the law then applies not only to the adjusted unit cost of commodities but also to combinations of commodity-attributes. This application of the law forms the basis of the Price index. The extension applies as well to price differences across times. The empirical movements of real exchange rates pose an enduring puzzle for economic theory (Stein 1995, Harvey 1996, Chen and Rogoff 2002). Standard theory proposes two distinct, albeit complementary, models of real exchange rates. The first of these is the Purchasing Power Parity (PPP) hypothesis, which posits that some appropriately defined real exchanges rate will tend to be roughly constant over time (stationary). This is a widely tested proposition, and its empirical difficulties are legion. Nonetheless, it is often used as an empirical rule which is used to judge the sustainability of the observed real exchange rate. The second hypothesis is that over the long run the term of trade (i.e. the real exchange rate in terms of export and import prices) will automatically move so as to eliminate trade imbalances. This too has been difficult to sustain at an empirical proposition, largely because persistent trade imbalances are evident across most countries. The Law of One Price Assumptions The "law of one price" has acquired the status of a folk theorem. In recent years, however, it fared well neither empirically nor theoretically. For instance, Isard (1977), who tested the law states (p. 942): "In reality the law of one price is flagrantly and systematically violated by empirical data." Rogoff (1996) surveys the literature on the law and on the purchasing power parity (PPP), and reaches the same conclusion. Taylor and Taylor (2004) discuss the narrowing of the gap between the theory and the empirical findings and the tendency toward convergence. This points to serious conceptual difficulties and inadequacies with the notion of one price. David Ricardo argued that in the case of international trade, the terms of trade (the relative price of exports to imports, expressed in common currency) would pick up this function. He contended that each nation's terms of trade would automatically adjust to balance its trade. This would thereby serve to automatically make all nations equally "competitive" in international trade, regardless of how backward their technology or how high their wages (Arndt and Richardson 1987). This implies providing a sufficiently stable and foreseeable macroeconomic environment so that planning can be undertaken and investments made to allocate resources efficiently. It also requires that domestic prices reflect as well as possible the opportunity cost of those resources. The picture changes if one allows for differences between foreign and domestic assets due to variations in risk, as in the portfolio balance model. The literature on monetary and exchange rate policies in developing countries has often emphasized the limited flexibility of nominal prices (Basu and Taylor 1999), to the point of arguing that "deviations from PPP are always and everywhere a monetary phenomenon" (Taylor 2000). Real effects on real exchange rates appear to be potentially quite important, and perfect price flexibility does not eliminate the adjustment problems of an economy with nominal contracting, and similarly with floating exchange rates when financial contracts are denominated in foreign currencies. The traditional debt-deflation theme (Fisher 1933) which stresses the effects of price movements on the net worth of debtors, and through that, on the supply of credit, has regained prominence in recent discussions, as attention has turned again to the role of monetary policies in financial crises (Islam 2000). Another point concerns uncertainty. Recent literature has incorporated the fact that there is no precise knowledge about a definite and unique model that would generate the evolution of the macroeconomic variables of interest (Taylor 1999; Hansen and Sargent, 2001). The complication is a part of the policy problem, and its recognition leads to realize the convenience that policy recommendations be robust with respect to changes in how the model of the economy is specified (Hansen and Sargent, 2000). The uncertainty about the specification of the "right" model and about the quantitative value of parameters can be expected to be particularly intense in economies undergoing transitions, because of policy reforms or other reasons. Under those circumstances, "structural parameters" are likely to change, and, at the same time, their identification will be made more difficult by the behavioral adjustments that take place as agents learn to operate in a new environment. Conclusions Therefore, while purchase power parity is a widely used economic model of trade interactions, the underlying assumption that relative price controls the exchange rate and cost/price of goods is simply an assumption, and can not be validated on all accounts, specifically in regards to the law of one price. Total "value" consist of some combination of prices and costs, the former referring to the part paid by the user of the service, the latter representing the part covered by the public sector. Not only do public/private ratios differ between countries and services, but reliable information on the magnitude of unit costs, i.e. the public part, is often very difficult and sometimes impossible to obtain. For this reason, the price-collecting procedure involves indirect price comparisons, where the aim is to complement directly collected private sector prices by data on input prices of selected services (The World Bank 2004) The recognition of purchase power parity as a classic theory argues that international relative prices are determined in the same way as national relative prices, by the appropriate relative real costs of production and trade, taking into account the cost of transportation of goods only. Although this may be affected by trade imbalances insofar as the latter affect real costs, it will not automatically move so as to balance trade. In classical theory it is a country's international competitive position, as measured by its real costs, which determines how it fares in international trade - not the other way around. As in the case of inter-regional trade within a nation, trade between nations will punish the weak and reward the strong, with no guarantee that it will provide benefits to all. Persistent trade imbalances are perfectly possible, covered by corresponding capital inflows or outflows. Furthermore, the trade baskets must be in the same context, and therefore PPP is highly equilibrium based. However, the differences in theory argue the hypothesis of Purchasing Power Parity (PPP). Purchasing power parity-based theories of exchange rate determination perform poorly in terms of its track record of actually predicting changes in exchange rates. However, PPP in either of its variants (relative or absolute) is not a total disaster as a predictor. There is an emphasis that international competition links the international prices of any particular tradable good, subject to differences arising from transportation costs, tariffs, and national taxes. International relative prices will be regulated by the corresponding real costs of the dominant producers. This applies equally well to any particular bundle of goods. Thus, for example, the international relative price of the tradable goods of any two countries (which is their real exchange rate in terms of tradable goods) will depend on the relative real costs of these goods. Since these relative real costs can change over time, it follows that the real exchange rate will not generally be stationary - i.e. PPP will not generally hold. The only exception would be the case in which both countries have the same composition of tradable goods bundles in each year. In that instance, the real costs of the two bundles would also be the same in every year, which means that their relative real costs would be constant over time. Only in this particular case would PPP hold. Nevertheless, GDP level PPPs are commonly used in international comparisons of health expenditure, overlooking the fact that cross-country differences in health care prices are not necessarily consistent with differences in prices in general. On the other hand, the GDP level PPPs are derived from price and expenditure data collected at sub-aggregates of the GDP, and in principle, conversion rates estimated from these data could be applied to comparisons involving sub-components, such as food expenditure or health services. However, with the current data quality and degree of comparability underlying these estimates, it is not clear if the application of such component-specific PPP rates would yield more reliable volume comparisons than the application of aggregate PPPs or even exchange rates. References Arndt, SW and Richardson JD 1987 (eds) Real-Financial Linkages among Open Economies, The MIT Press, Cambridge, Massachusetts. Atkeson Andrew and Burstein Ariel (2005) Trade Costs, Pricing-to-Market, and International Relative Prices [online] [Accessed July 5, 2006] from http://www.econ.ucla.edu/arielb/ABPricingtoMarket.pdf Basu, S. and A. M. Taylor (1999), "Business Cycles in International Historical Perspective", Journal of Economic Perspectives, Vol. 13, Spring. pp. 45-68. [online] [Accessed July 5, 2006] from http://www.jstor.org Chen, Yu-Chin and Kenneth Rogoff, 2002. "Commodity Currencies and Empirical Exchange Rate Puzzles", IMF, Working Paper 02/27. 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