Purchasing Power Parity - Essay Example

b. Error: Reference source not found Introduction 1 Background 2 Absolute Purchasing Power Parity (Absolute PPP) 2 Relative Purchasing Power Parity (Relative PPP) 2 Critical Review 3 Comparison between Relative PPP and Absolute PPP 3 Empirical evidence of Absolute and Relative PPP 3 Argument against Purchasing Power Parity 4 Measurement problem in testing for PPP 4 Conclusion 5 Introduction Purchasing Power Parity is an economic theory and a technique used to determine the economic value of two currencies. It decreases the effects of shifts in a nationwide currency. Moreover this is an issue when calculating a nation’s GDP. It shows how the exchange rate of two currencies should reflect the purchasing power of the people in two countries. The concept is based on the law of 1 price, which means that in the absence of transaction cost and official trade barriers, the goods which are identical will have the similar price in different markets when the prices are expressed in the same currency. The long term consequence of using PPP technique is that: for example, a retailer uses the equation to find that whether products can be purchased in low price in foreign country or not. Over time, if products are purchased at cheaper price then it will lead to an increase in price in foreign country. The country which was selling its product at higher rate at the same time will have to decrease its price of product, once demand slows. The idea behind this long term PPP is that despite if their comes a difference in currencies, the two countries will ultimately offer the same product for the same price (wisegeek, 2013, p.1). Background Absolute Purchasing Power Parity (Absolute PPP) It state that the similar basket of goods should be sold for the similar price all over the place. It is based on law of 1 price ( Econ, 2000, p.1). For absolute PPP following conditions must be met. First the price index for each of the two countries must be comprised of the same basket of goods. Second the goods of each country must be freely tradable on the international market. And third, all of the prices need to be indexed to the same year (Officer, 1978. P.562) Relative Purchasing Power Parity (Relative PPP) It states that the country which is having high inflation rate is weak in terms of currency, because inflation reduces the real purchasing power of a nation’s currency. It predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period which means that the exchange rate of two currencies reflects the effect of inflation rate (Murphy, p.1). Critical Review Comparison between Relative PPP and Absolute PPP Absolute PPP states that the value of 2 currencies change in contrary proportion to the changes in the ratio of price levels. On the other hand relative PPP predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. Empirical evidence of Absolute and Relative PPP Absolute PPP is based on law of one price that is tested for basket of commodities or individual commodities. The relative PPP approximates the change in individual price by change in price indices. Empirical evidence of absolute PPP: An orange costs 3 dollar in country A and the same orange costs 6 dollars in country B. This means 3 dollar in country A equals to 6 dollar in country B. This exchange rate is based on cost of orange and it is assumed that the cost of orange is same worldwide. Empirical evidence of relative PPP: Japan’s anticipated annual rate of inflation is equal to 6% per year, while the anticipated annual inflation rate for the U.S. is 3%. As an approximation, it is expected that the Japanese yen would devalued at the rate of 4% a year. Argument against Purchasing Power Parity The whole concept is based on unrealistic assumptions. That’s why forex market does not take into consideration the purchasing power parity. Those assumptions were basket of goods and services in the CPI is the same in all countries, no transportation cost, and consumptions patterns are the same all over the world. Measurement problem in testing for PPP For Absolute PPP: Suppose apples are currently priced at $5 a kilo in the U.S., that apples are prices at -5.50 per kilo in Europe, and that the exchange rate is 1.10 Euros per dollar. Now suppose that the price of apples goes up to -6.05 per kilo (a 10% increase) in Europe, while the price of apples in the U.S. only goes up on 5%, to $5.25 a kilo. If there is no depreciation in the euro to offset the 5% difference, then European apples will not be competitive on the international market and trade flowing from the U.S. to Europe will greatly decrease. For relative PPP: (Assume $1 per Rs. 115). The current spot exchange rate is S0 = 115 Rs. Per dollar. The expected annual inflation rate is 4.89% for U.S. and the annual expected inflation rate of India is 6.23%. Calculate the expected spot rate one year from now and the approximate expected spot rate. S1 / S0 = (1 + Iy) / (1 + Ix) S0 = Rs. 115 per dollar. (1 + Iy) = 1.0489 and (1 + Ix) = 1.0623. The approximation method would indicate that the Rs. Should decline against the dollar by : ( Iy – Ix) = ( 1.0489 – 1.0623) = -0.0134 = -1.34% So the value of the rupee relative to the dollar would be expected to decline to: ( 1 – 0.0134) * 115 = Rs. 113.46 per $ The answer can be calculated more exactly as: S1 = (1.0489) / (1.0623) * 115 = Rs. 113.55 per $. Conclusion In order to fight inflation and manage their macro policies, the developing countries always try to handle their nominal exchange rate. If policies are successful, relative prices adjust to changes in the nominal exchange rate, by implying that in these countries real exchange rates should be stationary or they should relapse to their means. For implication of policy, countries should estimate the success of the exchange rate system to keep the equilibrium real effective exchange rate. References Dorrucci, E. and McKay, J., 2011. The International Monetary System After The Financial Crisis. 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