Application of PPP in the Short Run - Essay Example

?[Application of PPP in the Short Run] By Insert Presented to Location Due Introduction Purchasing Power Parity (PPP) is a theory that asserts that residents in a single country in the globe should be in a position to buy good in the same price as residents of s different country. Thanks to globalization of trade, the prices of goods and services in the market are being driven by the global prices. Globalization has allowed for stiff competition in the market which has led to people choosing the best prices of goods. As result, people who sell their goods at extremely high prices have been forced to tone down by the market forces reading to creation of uniform prices of goods. International trade has then been seen to lead to an equalization of purchasing power which economist describe as parity. However, this theory has been seen to have many shortcomings (Wallace, 2007: 34). For instances, the prices of different goods cannot be the same in all countries. This is because there are barriers to trade which lead to the prices increasing gradually as they pass from one country to the next. These include the tariffs, taxes and shipment costs. For instance, a car in America may cost only $5000 but when it is shipped a country such as South Africa, its final cost is $2000 higher than the price it is sold at in America. Other commodities of trade because of their nature cannot be imported to another country. These include services such giving haircuts or other products such as real estate. Moreover, a person in a rural village in Brazil may not have the luxury of choosing different goods or services on the international market and may just end up buying good on the prices offered in their country. Moreover, not all types of goods and services have demand in every country. For instance, America may not have a specific price for a rice harvester because it does not grow rice. The price of a rice harvester would thus only be determined by the countries which have a demand for it such as Vietnam. The cost of living in different countries is different and this definitely affects their purchasing power. For instance, the cost of living in China is way low compared to the cost of living in America (Ullrich, 2009: 78). China applies the strategy of reducing the cost of living in her country so that it can pay her workers lower wages reducing the production cost. This makes her exports cheaper compared to that of other players in the global market giving it a competitive edge. In some instances, PPP has been used to position the exchange rates of new countries or even predict expectations on future exchange rates. There are two versions of PPP that have been used by economist all over the globe. These are relative and absolute PPP. Absolute PPP is the equalization of good’s prices in different countries. Relative PPP on the other hand asserts that the change of exchange rates over time between different countries is relative to the change in prices of standards goods in these countries (Obstfeld &Taylor, 2004: 318).PPP has been seen to prove to hold true in its assumptions in the long run. This is because as a result of removal of trade barriers and enhancement of free trade in the globe, the price of standard goods without the inclusion of costs such as shipment costs, tariffs and taxes is similar around the globe. It would take years for prices of products to be equalized in the globe. However, various economists have argued that PPP do not hold true in the short run. This is because the exchange rates are controlled by the news in the short run. News regarding change in the perceptions of the development of exchange rates in the future has an immediate effect on the current exchange rate. The rates are also influenced by other announcement such as interest rate changes. This paper studies PPP and exchange rates in EU and US to show how PPP cannot hold in the short-term. In the developing countries, PPP is measures using a comparison of the official exchange rate (OER) gauge (Butler, 2012: 210). The PPP of other developed countries is measured using their GDP because the value of their currencies is close to that one used by EU and US. Using the PPP in relation to US and EU currencies The theory of purchasing power parity compares the prices of goods across different countries. The ratio of price levels of different goods in between two countries is equivalent to the exchange rate between these two countries. PPP therefore predicts a Euro/ Dollar exchange rate of: E$?=Pus/ PE (15-1) Where: PUS – Dollar price of a reference commodity sold in US PE -Euro price of a the reference commodity in Europe In order to understand why PPP would not work in the short term, it is important to first look at The Law of One price. This law holds that in similar goods should be sold in the same prices if expressed in the same currency. For instance, is a skinny jeans sells at ?30 in London then it should be sold at $45 in New York. This only applies in markets where there are no trade barriers such as transportation costs, and they are free competitive markets (Ullrich, 2009: 75). This implies that the dollar price of a good denoted by I in the equation below does not change in any country where it is sold. Pi US = (E $/€) ? (PI E) Pi US – is the dollar price of commodity i sold in America PI E - price of the same commodity in Europe E $/€) – is the euro/dollar exchange rate PPP is related the law of One Price in that the latter compares prices of a commodity while the theory looks at the general price levels. This has an implication that if the Law of One Price can hold true, then PPP would ultimately hold true too (Butler, 2012: 231). However, supporters of the PPP theory assert that the validity of the PPP theory is not bound to the law of one price. As has already been stated, there are two types of PPP, absolute and relative PPP. In this cases since we are comparing the PPP of America and Europe, we are going to apply the relative PPP. The relative PPP is stated that the change in the national price levels of two countries which are compared over time is equivalent to the relative change in exchange rates between the two countries. As such, the relative PPP between America and Europe would be expressed as in the equation below: (E$/€, t - E$/€, t-1)/ E$/€, t-1 = ? US,t – ? E,t ?t is the inflation rates In the long run, the interaction in trade between America and Europe is seen to have some specific effects. In terms of monetary supply, an increase in the American currency money supply results in a long run depreciation of the dollar against the euro. The opposite is true in case of an increase in the Euro supply. In terms of interest rates, a hike of the interest rates on the euro causes a depreciation of the euro against the dollar and the opposite is again true. In terms of output, an increase in output from any of these country results in appreciation of that country’s currency against the other (Obstfeld & Taylor, 2004: 276). Based on this model, it can be observed that maintaining a constant money supply pattern results in the consistent rise in the level of inflation. In the long run, the interest rate is also seen to be tied to the money supply. Moreover, a fall/ rise in a country inflation rate is expected to result in the same fall or rise in the interest rates and this has been called the Fishers effect. , despite the fact that all these figures and equations are seen to be convincing, there is little real life empirical evidence that support PPP and the Law of One price theories. Three main reasons have been put forward to explain these disparities. One is the international differences in measurement of price. Depending on the unique features of a country such as the level of economic development, the prices of similar goods tend to be different. The price is also affected by the ease in which a country can process a certain product which is again influenced by diverse factors. The other reason is the existence of trade barriers in terms of tariffs and taxes and also non-tradable (Alexander, 2006: 96). There are some goods or services that cannot be transferred from one country to another. This lack of mobility makes it hard for such commodities to compete effectively in the market leading to creation of unique prices in different locations or countries. Another reason has been that some countries, despite the fact that they signed the agreement of allowing free trade in their country, they have departed from the free trade competition. This has been as a result of these countries experiencing the negative effects of free trade. This is because, although free trade has been seen to be effective in promoting world economies, the developed countries have benefitted more compared to the emerging and developing countries. This is because the developed countries, because of the resources they have are able to shine above companies in the developing countries who lack such resources (Morales, 2006: 419). In the end, the companies in the developed countries thrive while those from the developing countries are suffocated and some eventually collapse. Governments have developed restrictions that enable their home companies thrive without being exposed to the unfair competition provided by the global markets. This has to a great extent affected free trade. The deviations in PPP have been seen to be greater in the short run compared to the long run. For instance, in a case where there is a sudden depreciation in the value of the dollar against other currencies will result in a huge disparity in a standard commodity in America in comparison to the other countries. AS has thus been observed, PPP does not apply in the short run. This has serious implications in the creation of the monetary policies. One of the implications is that it refutes the possibility of sustaining a pegged exchange rate system through manipulation of the monetary growth in relation to relative price levels (Choi, 2003: 67). There are permanent changes in the parity values of purchasing power. This implies that using deterministic parity would only result in huge deviations from the real parity which further increases with time. In this case, maintaining of a pegged rate system in the short run can be effective. However countries need to ensure that the exchange rate system maintains a balance of payment as a way of ensuring that the domestic price levels changes at the same rate with the foreign price levels (Jones & Kenen, 2001: 91). For instance, if the two countries in comparison use constant growth rates or inflation rates, then prediction their exchange rates in the future become hard. It has also been observed that neither absolute nor relative PPP end to hold in the short run. This is because there have not been huge movements in relative prices. Looking at the development of exchange rates in America over several decades can be used to show how PPP works in the long run and not in the short run. American dollar under the Breton Wood agreement had been pegged to the value of gold. Other countries’ currencies were then pegged to the dollar. However in the 1973, President Nixon removed the convertibility of the Dollar to God and it now stood as its own value. This led to other currencies floating against each other (OECD, 2009: 129). The exchange rate at this time was determined by the monetary approach. This approach was under the assumption that PPP held constant at all times. This strategy was based on the notion that since the exchange rate of two currencies is the relative price of the currencies, and then it can be determined through the measure of their demand and supply in the asset market. Empirical studies have been conducted to see whether PPP did actually hold in the 1970s. They have shown that PPP did actually hold in the first two years. This could be attributed to the fact that the value of the dollar remained constant in these years. However, there are huge disparities in the PPP in the late 1970s. This is because the dollar became highly volatile and it took sometime before the other currencies could adjust to each change in the value of the dollar. This in the end resulted in huge disparity in the value of the dollar. It is the real exchange value that determines PPP and this explains why PPP may not hold in the short run. Conclusion As has been observed, PPP is not likely to hold in the short run as a result of the abrupt changes that may result in the changes of the currency values and it takes time for the exchange system to adjust. However, PPP has been observed to hold true in the long run when there has been enough time to be able to compare the relative prices. This does not however mean that PPP theory is invalid. It has been effective in explaining why the currencies of some trading countries appreciate or depreciate. Reference List Alexander, V. (2006). Global divergence in trade, money and policy. Cheltenham [u.a.], Edward Elgar. Butler, K. C. (2012). Multinational finance evaluating opportunities, costs, and risks of operations. Hoboken, N.J., John Wiley. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=480242. Choi, F. D. S. 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