Purchasing Power Parity - Coursework Example

PURCHASING POWER PARITY "Purchasing power parity" or "PPP" expresses the notion that with a unit of purchasing power, say one dollar or one euro, it should be possible to purchase the same bundle of goods and services anywhere in the world (Neary, 2004). In economics, purchasing power parity (PPP) is the method of using the long-run equilibrium exchange rate of two currencies to equalize the currencies purchasing power. It is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price. Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries relative inflation rates and the change in the exchange rate of their currencies (Wikipedia, 2006). It is important in international economics for at least three reasons. First, it provides a particularly simple theory of exchange rate determination: it predicts that, if the relative price of two currencies is flexible, then it will adjust to equal the ratio of their price levels. Second, if this kind of adjustment does not take place, the ratio of price levels can nonetheless provide a reference point against which the current exchange rate can be deemed to be "under- or over-valued" relative to its PPP level. Finally, irrespective of whether PPP will ever occur in practice, deviations from it must be taken into account in making international and interregional comparisons of real income (Neary, 2004). Theoretical Framework: The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP suggests that transactions on a countrys current account, affect the value of the exchange rate on the foreign exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate (Suranovic, 1999). Although earlier studies, like Froot and Rogoff (1995) had reported evidence of short run violations, many economists as Mc Donald (1996), Wu (1996) and others still hold the view that over the long run, relative price may move in proportion to the nominal exchange rate so that the real exchange rate will revert to its parity. Hence, it becomes important to test PPP as a long run relationship. PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one price. The Law of One Price (LoOP) The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Take for example the following information about movie video tapes sold in the US and Mexican markets. Price of videos in US market (P$v) $20 Price of videos in Mexican market (Ppv) p150 Spot exchange rate (Ep/$) 10 p/$ The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by the spot exchange rate as shown, To see why the peso price is divided by the exchange rate (rather than multiplied) notice the conversion of units shown in the brackets. If the law of one price held, then the dollar price in Mexico should match the price in the US. Since the dollar price of the video is less than the dollar price in the US, the law of one price does not hold in this circumstance. The next question to ask is what might happen as a result of the discrepancy in prices. Well, as long as there are no costs incurred to transport the goods, there is a profit-making opportunity through trade. For example, US travellers in Mexico who recognize that identical video titles are selling there for 25% less might buy videos in Mexico and bring them back to the US to sell. This is an example of "goods arbitrage." An arbitrage opportunity arises whenever one can buy something at a low price in one location and resell at a higher price and thus make a profit. Using basic supply and demand theory, the increase in demand for videos in Mexico would push the price of videos up. The increase supply of videos on the US market would force the price down in the US. In the end the price of videos in Mexico may rise to, say, 180 pesos while the price of videos in the US may fall to $18. At these new prices the law of one price holds since, The idea between the law of one price is that identical goods selling in an integrated market, where there are no transportation costs or differential taxes or subsidies, should sell at identical prices. If different prices prevailed then there would be profit-making opportunities by buying the good in the low price market and reselling it in the high price market. If entrepreneurs acted in this way, then the prices would converge to equality. Of course, for many reasons the law of one price does not hold even between markets within a country. The price of beer, gasoline and stereos will likely be different in New York City than in Los Angeles. The price of these items will also be different in other countries when converted at current exchange rates. The simple reason for the discrepancies is that there are costs to transport goods between locations, there are different taxes applied in different states and different countries, non-tradable input prices may vary, and people do not have perfect information about the prices of goods in all markets at all times. Thus, to refer to this as an economic "law" does seem to exaggerate its validity. From LoOP to PPP The purchasing power parity theory is really just the law of one price applied in the aggregate, but, with a slight twist added (more on the twist a bit later). If it makes sense from the law of one price that identical goods should sell for identical prices in different markets, then the law ought to hold for all identical goods sold in both markets. First, lets define the variable CB$ to be the cost of a basket of goods in the US denominated in dollars. For simplicity we could imagine using the same basket of goods used in the construction of the US consumer price index (CPI$). The CPI uses a market basket of goods which are purchased by an average household during a specified period. The basket is determined by surveying the quantity of different items purchased by many different households. One can then determine, on average, how many units of bread, milk, cheese, rent, electricity, etc. are purchased by the typical household. You might imagine, its as if all products are purchased in a grocery store, with items being placed in a basket before the purchase is made. CB$ then represents the dollar cost of purchasing all of the items in the market basket. We shall similarly define CBp to be the cost of a market basket of goods in Mexico denominated in pesos. Now if the law of one price holds for each individual item in the market basket, then it should hold for the market baskets as well. In other words, Rewriting the right-hand side equation allows us to put the relationship in the form commonly used to describe absolute purchasing power parity. Namely, If this condition holds between two countries then we would say PPP is satisfied. The condition says that the PPP exchange rate (pesos per dollars) will equal the ratio of the costs of the two market baskets of goods denominated in local currency units. Note that the reciprocal relationship is also valid. Because the cost of a market basket of goods is used in the construction of the countrys consumer price index, PPP is often written as a relationship between the exchange rate and the countrys price indices. However, it is not possible merely to substitute the price index directly for the cost of the market basket used above. To see why, lets review the construction of the CPI (Suranovic, 1999). PPP must hold if the prices of all goods are equalised internationally by arbitrage, leading to the "law of one price". However, detailed studies of individual markets have shown that deviations from this "law" are substantial. Reasons for this are not hard to find. Some goods and many kinds of services are not traded at all. Even traded goods face many barriers to arbitrage, including tariffs, transport costs, product differentiation, and price discrimination by firms with market power. There is now a growing body of evidence, summarised by Anderson and van Wincoop (2004), that such barriers are pervasive, implying that modern economies remain relatively unintegrated, despite the extensive trade liberalisation that has occurred in the half-century since the Second World War. Even when goods are traded freely, their prices to final consumers are affected by local distributional and related costs. Presumably for this reason, PPP is often found to hold better for producer prices than for consumer prices. A huge empirical literature, surveyed in Froot and Rogoff (1995) and Taylor and Taylor (2004), documents the extent of deviations from PPP and attempts to determine whether they are permanent or temporary. This can alternatively be described as investigating the behaviour of the "real exchange rate", defined as the ratio of the home to the foreign price level expressed in terms of a common currency, p/ep*. (Here p and p* denote the home and foreign price level respectively, while e denotes the nominal exchange rate, measured as the price in home currency of a unit of foreign currency.) If PPP holds in its absolute version, p equals ep*, and the real exchange rate is one. A weaker form of PPP is the relative version, which requires that p is proportional to ep*, so the real exchange rate is constant (Neary, 2004). The essence of PPP is that the price levels in the respective countries influence the exchange rate between two currencies. The theory is based on the basis of the law of one price (LOP), which implies that once converted to a common currency, the same good should sell for the same price in different countries. Alternatively, for any good i, Pi = EPi* Where Pi is the domestic price for ith good, measured in domestic currency, Pi* is the foreign price for ith good measured in foreign currency, and E is the domestic nominal exchange rate (domestic currency to foreign currency). The Law of One Price can be extended to a price index by taking a weighted average of the price of each good. Therefore, absolute Purchasing power parity (APPP) is P = EP*, or E = P/P*. Where P(P*) is the domestic (foreign) price level. But APPP (absolute purchasing power parity) has some drawbacks. Firstly, the basket of goods used to measure the price index in each country should be identical in each country. If there are no trade barriers, transportation costs of imperfect competition, and the basket of goods and their relative weights are identical in both countries, the rate of change in the exchange rate should equal to the rate of change in the price level ratio. Let us assume that the production market condition above is a constant, C, which means E = C P/P* or, C = E P*/P which is nothing but the real exchange rate. Absolute PPP holds when C = 1. Relative PPP is obtained by log differentiating E = CP/P*, at time t, Ë/E = P& /P – P*/ P& So, relative PPP might be valid, even if absolute PPP is not. If the increase in domestic process is faster as compared to that of the foreign country, then the exchange rate will depreciate. Another way of interpreting the PPP doctrine is that real exchange rates should be mean reverting. This implies that in response to any shock or disturbance, the real exchange rate must return to its PPP defined level. This is a useful interpretation as it can be empirically testable. Rejection of unit root hypothesis indicates mean reversion in real exchange rates (Paul, N.D.). PPP works better for countries with high inflation rates, and best of all in periods of hyperinflation. Such exceptional periods aside, short-run studies have difficulty rejecting the hypothesis that real exchange rates follow a random walk with no tendency to return to an equilibrium level. Studies using long-run data find evidence of reversion towards PPP but at a very slow rate: it takes between three and five years before half the deviation is eliminated. This generates what Rogoff (1996) has called the "PPP puzzle": in the post-Bretton Woods era of floating nominal exchange rates, real exchange rates are extremely volatile in the short run and converge very slowly to equilibrium. Short-run deviations from PPP can be explained by high volatility in the nominal exchange rate, presumably due to the volatility of its underlying financial determinants, combined with nominal price stickiness. But such short-run stickiness is hard to reconcile with the very slow rate at which deviations from PPP are eliminated. Recent research suggests a number of explanations for the puzzle, including nonlinear dynamics, so reversion to PPP occurs rapidly for large deviations but much less so for small ones, and heterogeneity between goods in their rates of price convergence. However, a fully satisfactory explanation of the data remains elusive. In fact there are many reasons why we should not expect PPP to hold even in the long run. Best known of these is the "Balassa-Samuelson effect" due to Balassa (1964) and Samuelson (1964). If high-income countries have a greater relative productivity advantage in the production of traded goods, they will produce such goods relatively more cheaply. If the law of one price applies to traded goods, so their nominal prices are equalised internationally, then the relative price of non-traded goods will be lower in low-income countries, implying systematic deviations from PPP even in the long run. As shown in Neary (1988), the Balassa-Samuelson effect is only one source of potential long-run deviations from PPP. Another is the so-called "Dutch Disease", whereby a sudden increase in productivity in an export sector (due for example to a rapid development of natural resources) causes a real exchange rate appreciation, leading to a loss in competitiveness for other non-booming traded sectors. Other possible explanations include changes in the terms of trade (the external relative price of imports and exports), changes in the government’s fiscal stance, and changes in a country’s level of external indebtedness (Neary, 2004). Conclusion The PPP doctrine is an important assumption in most models in international economics. The theory of PPP throws light on some important factors, which affect the exchange rate movements. It has also been used as a basis for determining the exchange rate levels, and also in comparing income levels between countries, which takes a researcher a step ahead to establish its validity. References Balassa, B. (1964). The Purchasing-Power Parity Doctrine: A Reappraisal. Journal of Political Economy. 72: 584-596. Froot, K.A., and Rogoff, K., (1995), Perspectives on PPP and Long-Run Real Exchange Rates, in Handbook of International Economics, (ed.) Grossman, G. and Rogoff, K., Vol. III, Elsevier Science. MacDonald, Ronald, (1996), Panel Unit Root Tests and Real Exchange Rates, Economics Letters, 50, 7-11. Neary, J. Peter (1988). Determinants of the Equilibrium Real Exchange Rate. American Economic Review. 78: 210-215. Neary, P.J. (2004) Purchasing Power Parity. Prepared for Encyclopedia of World Trade Since 1450, ed. J.J. McCusker et al., New York: Macmillan Reference. Paul, M. (N.D.) Empirical evidence of Purchasing Power Parity in six South East Asian Countries – A Panel Data Approach. [Online] Institute of Economic Growth, University of Delhi Enclave, Delhi. Available from: [Accessed 12 November, 2006] Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34: 647-668. Samuelson, P. A. (1964). Theoretical Notes on Trade Problems. Review of Economics and Statistics. 46: 145-154. Suranovic, S. (1999) Introduction to Purchasing Power Parity (PPP). [Online] Available from: [Accessed 12 November, 2006] Taylor, Alan M. and Mark P. Taylor (2004). The Purchasing Power Parity Debate. Journal of Economic Perspectives. Wikipedia, (2006) Purchasing power parity. [Online] Wikimedia Foundation, Inc. Available from: [Accessed 12 November, 2006] Wu, Y, (1996), Are Real Exchange Rates Nonstationary? Evidence from a Panel Data Test, Journal of Money, Credit and Banking, 28 (1), 54-63. Read More