Purchasing Power Parity Theory - Essay Example

Running Head: Parity Theories Parity Theories [Institute’s Parity Theories Purchasing Power Parity Theory Purchasing power parity theory of exchange rate is based on the idea of equivalence in the purchasing power of countries, which leads to equilibrium in the exchange rate between the currencies of countries. This simply indicates uniformity in the prices of fixed number of goods and services and exchange rate of two countries. The roots of this theory lie in the law of one price, which says that homogenous goods should have identical prices universally not including any carrying or shipping costs under the prevalence of perfect competition if the pertinent national prices are stated in a common currency. The law of one price has certain conditions, which must exist in order for this law to be applicable. Firstly, it is the presence of competitive market for goods and services in two countries (EconomyWatch, 2010). Secondly, presence of goods and services that two countries can trade between themselves and lastly, checking of transportation and other operational expenses, which are obstructions in trade. Taking example of McDonald’s Big Mac hamburger prices around the world, one can understand this concept. For this the one should take the prices of all the countries in common currency, therefore dollar would be the appropriate one as every currency’s appreciation or depreciation is measured in terms of dollar (Taylor and Taylor, 2004, pp.135-158). In January 2004, the price of hamburger in United States was $2.80 where as in China it was $1.23, least expensive of all countries, this shows that China’s currency was underrated by 56%. However, in case of Euro zone, the currency was overrated by 24% as the price of Big Mac was $3.48 in that zone. Japan’s currency that is yen was underrated by 12% and the price of Big Mac was $2.46 in Japan. If one ponders over the idea that why is there so much difference in the prices of same thing in different countries and why purchasing power parity should be implemented in the world one comes up with various ideas. Firstly, the prices vary because in each country different raw materials and services have different costs and values. A country that produces tea in an excess amount, tea might not be very expensive in that country simultaneously bread might be very expensive in that country due to scarcity of wheat. Moreover, wage rate of the person serving foods at restaurant, rent of place of restaurant, and many other factors in case of businesses other that restaurants, have different costs and values in different countries therefore final prices become very different due to these inputs. In response of question that why countries should adopt Purchasing Power Parity Theory when there are so many discrepancies, one can say that in long-term PPP theory has good effects on the economy of a country. A big retailer may use this theory to find that in what countries products possess lesser prices than the domestic country so that the retailer can approach them. This would increase the demand of that product in the country in which it is of low price leading to increase in price (Murray and Papell, 2005, pp. 410-415). Simultaneously, the countries that were selling the product at a higher price would somehow manage to lower the prices so that demand increases and people purchases from them. Ultimately, both countries would start offering same prices in spite of differences in the currencies. There are two types of purchasing power parity theories; these are Absolute purchasing power parity and relative purchasing power parity. Absolute purchasing power parity theory suggests that if the prices of goods convert into same currency then a basket of goods would have same cost in the native country as well as abroad. In simple words, absolute purchasing power parity theory assumes that the purchasing power of money should be identical between countries. On the other hand, relative purchasing power parity theory focuses on changes in purchasing power rather than making comparison between domestic and foreign country’s buying power. Relative purchasing power parity theory therefore states that inverse variations in the nominal exchange rate compensate the inflation differences between two countries leading to constant ratio of buying power between two countries. Absolute purchasing power parity is true when domestic economy and foreign economy have same purchasing power in terms of currency units, once it exchanges into foreign currency at the market exchange rate. Nevertheless, it is pretty difficult to decide whether actually the same basket of goods is obtainable in two different countries or not. Hence, it is general to examine Relative Purchasing Power Parity, according to which the percentage difference in the exchange rate for a given time just compensates the difference in inflation rates in the countries for the same time span. If Absolute Purchasing Power Parity is true, it makes must the trueness of Relative Purchasing power Parity. Conversely, if Relative PPP is true, then Absolute PPP is not necessarily true, because it is likely that regular changes in nominal exchange rates happen at different stages of purchasing power for the two currencies because of many reasons like transaction cost and wage rate. Neither absolute nor relative PPP appear to hold closely. In the short run, both Absolute and Relative Purchasing Power Parity does not hold completely however they have relatively good impacts in long-run when have large big shifts in prices. They hold in producer price indices rather than consumer price indices. From the beginning 1970s, the purchasing power parity theory of has been the matter of a constant and dynamic debate. Mostly during that period, hypothetical work recommended that exchange rates are supposed to be associated with comparative alterations within ‘price levels’ with variations that might be negligible or transitory. Despite the fact that pragmatic work could get just the “flimsiest proof” (Ong, 2003, p. 102) for purchasing power parity, and even these unstable results involve a very sluggish pace of degeneration to PPP of, “at best, three to five years” (Ong, 2003, p. 102). Following a great effort to get ‘common ground’, the distance amid hypothesis and empirics is being filled from both ways. Following the early dissatisfactions with “dynamic general equilibrium models” (Hillier, 1991, p. 76), topical uses with comparatively lesser price inflexibility reveal the way economic blows may have huge as well as ongoing consequences on the actual exchange rate. When these insights are merged with hypothetical work on operational outlays and nonlinearity, one can recognize the instability of the actual exchange rate. The existence of non-traded commodities enhances these models additionally. A fresh focus on the “Harrod-Balassa-Samuelson effect and wealth effects” (Hillier, 1991, p. 77) creates a customized analysis of purchasing power parity where the actual exchange rate itself may progress eventually. Examples would best illustrate Absolute and Relative purchasing power parity theories. Absolute Purchasing Power Parity Theory, For example, oranges cost $5 per dozen in the United Sates and they cost 6euros per dozen in the Europe and suppose that the exchange rate of two countries is 2 Euros per dollar. Suddenly, if the prices of oranges increase by 20% in Europe and become 7.2euros while they increase only by 10% in United States and become 5.5$ and there is no depreciation in Euro to compensate the difference of 10%, then European oranges would not be considered as economical on the international market and trade of oranges from US to Europe would significantly increase (Murray and Papell, 2005, pp. 361-369). If one takes weighted averages of prices for all goods in an economy, absolute purchasing power parity ensures that the currency exchange rate between two countries must be matching the ratio of price levels of the countries, otherwise one country’s goods will be competitive on international markets, and other country’s exports would suffer. However, there are certain conditions, which ensure the validity of this relation. Firstly, the goods of every country should be tradable on international market without any restriction. Secondly, the price index of both the countries should include same basket of goods and thirdly price indexes should have same year. Interest Rate Parity Theory Interest rate parity theory analyzes the relationship between the current and the consequent future rate of currencies. The Interest rate parity theory postulates that the premium or discount for the future exchange rate on the foreign currency reflects interest rate discrepancies between two in the absence of arbitrage. Arbitrage is the process of purchasing shares or currency in one financial market and selling it at a good return in another financial market. Additionally, the theory says that the size of the future premium or discount on a foreign currency must be equivalent to the interest rate discrepancies between the countries in contrast. There are two types of IRP, Covered interest rate parity and uncovered interest rate parity. Covered interest theory suggests that the exchange rate forward premiums and discounts compensate interest rate discrepancies between two countries. There is a lot of global debate among economists on whether there exists a sturdy as well as statistically important connection between alterations within a country’s interest rate and value of currency. The major limitation is that it does not consider a countrys ‘current account balance’, depending on investment flows instead. Certainly, it is expected to overstate investment flows, ignoring several additional aspects: political constancy, price rises, and financial development. Covered Interest Rate Examples: For example, Apple Inc., the U.S. based multi-national company, needs to pay its European employees in Euro in a two-month’s time. Apple Inc. can do this in various methods, it can either purchase Euro forward 30 days to lock in the exchange rate. Then Apple Inc. can invest in dollars for 60 days until it must change dollars to Euro in a two-month. This is covering because Apple Inc. has no exchange rate fluctuation risk. Alternatively, Apple Inc can change dollar to Euro today at current exchange rate. It can invest in a European bond in Euros for 60 days and give loan of equal amount in Euros for 60 days then pay its obligation in Euro at the end of the two months. This is covering method because by converting dollars to Euro at the current, the risk of exchange rate fluctuation reduces. Covered Interest Rate Parity deals with a risk-free return therefore it is likely to be true always and divergences stand for arbitrage opportunity. One can assume covered interest rate parity as a formula that concludes the value of the forward exchange rate. Researchers have suggested that the Covered Interest Rate Parity relationship is actually what banks mostly use to determine the value of the forward exchange rate. Uncovered Interest Rate Theory Uncovered Interest Rate theory suggests that anticipated appreciation or depreciation of a currency is compensated by lower or higher interest rate. Uncovered Interest Rate Example One method that Apple Inc. can adopt to pay its European employees after two months is that it can invest the money in dollars currently and change it in Euro at the end of two months (Rogoff, 1996, pp.647-668). This method is uncovered because the exchange rate risks are present in this situation. One the basis of data retrieved from the monthly report June 2004 of Deutsche Bundesbank, one can calculate an indicator of the German economy’s price competitiveness as a weighted average against 19 of Germany’s major trading partners. This report calculates two indicators, one from Eurostat data and other from World Bank data. It shows that at a value of 100, the prices of goods basket of Germany are identical to those abroad. At higher values, the price level in Germany is more than that of its trading partners. The growth in both indicators is parallel with one another. In 2000, the baskets of goods had a price level for Germany which is 5% or 6% lower than the average (n.d., 2004). Since that time, Germany’s competitiveness has got worsen and euro has appreciated. At the start of 2004, the price of the German basket of goods calculated in a way, which was one-eighth lower than on a weighted average against the 19 trading partners. This indicates that, even when one uses absolute purchasing power parity to measure competitiveness, one must make some allowance for a margin of doubt. One can also divide the competition indicators based on relative price levels into indicators against individual groups of countries. There are developments in indicators of Germany’s competitiveness in contrast with the other euro area countries and its main trading partners. It discloses that the level of prices in Germany has always been relatively high, particularly in association with the country’s euro-area trading partners. Nevertheless, recently, a trend towards junction of the price levels is manifest. On the other hand, the price level in Germany has always been lower than that of its non-euro-area trading partners in the last few years. Conversely, the competitive frame, which Germany acquired due to the weakness of the euro in 1999 and 2000, has now reduced again. Purchasing power parity theory can help the companies running globally in many ways. This theory also helps finding gross domestic product (GDP), which gives a good general way to measure the prosperity of different economies. Unluckily, if an economist measures GDP with the customary domestic currency rates, it can guide to an imprecise picture. Specialists often talk about China as a paragon, which deliberately devalues its currency. By adapting for the understood purchasing parity, that China has with the United States. China keeps its currency devalued because US imports more than 75% of china’s exports and if china does not do it then its exports would suffer. When a rigorous trade imbalance occurs between a nations exports and its imports, economists may suggest a variety of therapies to tackle this. A general remedy is to rigid trade barriers, which may further deform markets. Nevertheless, if, economists can examine the divergence between a nations purchasing power and its currency rate, the imbalance becomes much easier to correct (Taylora, 2006, pp. 1-17). Adjusting the currency to match actual purchasing power can resolve the issue without much trouble. If there are no obstructions to international arbitrage, similar goods should sell in the same price in two different countries at the same time (DePamphilis, 2011, pp.44-90). This absolute description of the Law of One Price for individual goods indirectly derives a relative description of the Law of One Price, which focuses on changes rather than degrees and a mixture of relative and absolute description which relates exchange rates and price indices is purchasing power parity theory. The derivation is based on assumptions which, if they do not hold exactly, can cause deviations from PPP. When it comes to a company, which operates globally, PPP theory is certainly the best one because it focuses on likeness of prices everywhere in the world. Moreover, this scenario is currently taking place in the world to some extent though not entirely. This theory reduces the differences, which appreciation or depreciation in the currency may cause and brings equality between the countries. References DePamphilis, D. 2011. Mergers, Acquisitions, and Other Restructuring Activities: An Integrated Approach to Process, Tools, Cases, and Solutions. Academic Press. EconomyWatch. 2010. Purchasing Power Parity Theory of Exchange Rate. Retrieved on March 17, 2012: www.economywatch.com Hillier, B. 1991. The Macroeconomic Debate: Models of the Closed and Open Economy. Wiley-Blackwell. Murray, C. J., and Papell, D. H. 2005. Do Panels Help Solve the Purchasing Power Parity Puzzle? Journal of Business and Economic Statistics, 410-415. Murray, C. J., and Papell, D. H. 2005. State of the Art Unit Root Tests and Purchasing Power Parity. Journal of Money, Credit, and Banking, 361-369. Narayan, P. K. 2007. New Evidence on Purchasing Power Parity From 17 OECD Countries. Applied Economics, 1063-1071. n.d. 2004. Purchasing Power Parity Theory as a Concept for Evaluating Price Competitiveness. Deutsche Bundesbank. Ong, L. L. 2003. The Big Mac Index: Applications of Purchasing Power Parity. Palgrave Macmillan. Rogoff, K. 1996. The Purchasing Power Parity Puzzle. Journal of Economic Literature, 647-668. Taylor, A. M., and Taylor, M. P. 2004. The Purchasing Power Parity Debate. Journal of Economic Perspectives, 135–158. Taylora, M. P. 2006. Real Exchange Rates and Purchasing Power Parity: Mean-Reversion in Economic Thought. Applied Financial Economics, 1-17. Read More