Notion of Purchasing Power Parity - Essay Example

Notion of purchasing power parity: It is defined as an economic theory that estimates the magnitude of variation and adjustment needed on the exchange rate between variouscountries in order for the exchange to be equal to the purchasing power and capability of each currency. PPP is mathematically represented as; S=P1 /P2 Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2 Purchasing Power Parity (PPP) is a perfect tool and component of economic theories that is used as yardstick to determine and compare the relative values of different currencies across the world. APP can be classified as either absolute PPP or relative PPP. Absolute PPP refers to the equalization and stabilization of price levels across countries while. Relative PPP refers to rates of changes of price levels or stated otherwise inflation rates. Basically ,that is the rate of appreciation of a currency is equal to the difference in inflation rates between the home and the foreign country Theories that have brought about pop assume that at some circumstances, it would cost exactly the same number of for exampleUs dollars to buy euros and then to use the proceeds to purchase the same basket as it would cost to use those US dollars directly in buying the market basket of goods. For example, a cake that sells for C$1.50 in Australian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both cakes cost US$1.00.) Therefore, the fundamental for PPP is the "law of one price". Consequently, on elimation or assumptiontransportation and other transaction costs, competitive markets will have same price for identical good in two countries, on expressing the prices of involved countries into the same currency. The concept and principle of purchasing power parity enables and aids in estimation of what the exchange rate between both currencies should be in order for the exchange to be the same with the purchasing capability of the currencies of the two countries. Thus, when a countrys domestic price level is increasing as it is in the case when it is experiencing inflation that countrys exchange rate must depreciated so as to stabilize the PPP. PPP exchange rates is significant in that it helps to avoid inaccurate and erroneous international comparisons that arise due to use of market exchange rates. A good example is when two countries output similar physical amounts of goods in two separate years. Due to adverse fluctuation in market exchange rates when the GDP of one country (measured in its own currency is converted to the other countrys currency using market exchange rates) one country can be deemed to have higher real GDP than the other country in one year but relatively lower in the other; both of these comparisons wouldmiss-reflect the reality of their relative levels of production. This would be averted by converting one countrys GDP into the other countrys currency using PPP exchange rates instead of observed market exchange However, there is a large gap between market- and PPP-based rates in developing countries, for most of which the ratio of the market and PPP U.S. dollar exchange rate ranges between 2 and 4. Furthermore, for developed economies, the market and PPP rates has a narrower range. Consequently, developing countries get a much higher weight in aggregations that use PPP exchange rates than they do using market exchange rates. Therefore, the choice of weights makes considerable difference in calculations of global growth, but little discrepancy to estimates of aggregate growth in developed economies. Merits of PPP: it ensures exchange rates are relatively stable over time. This is contrary to market rates that vary frequently. Thus using them could produce quite mega swings in aggregate measures of growth even when growth rates in specific countries are non-volatile. Also market-based rates are relevant only for internationally traded commodities. Nontrade goods and services tend to be cheaper in low-income than in high-income. This has eventually made PPP regarded as a suitable measure of well-being. Disadvantages of ppp; The principal drawback of is that PPP is harder and more involving to measure than market-based rates. Thus ICP is mostly preferred andadoptable because new price comparisons are available only at rare intervals. Secondly the PPP rates must be estimated, this can introduce inaccuracies into the measurement. This poses credibility tests to its methodology. Since ICP does not cover all countries, this means that data for missing countries has to be approximated. PPPs isused as a first step in making inter-country comparisons in real terms of gross domestic product (GDP). GDP is most frequently to represent the economic size of countries and, on a per capita basis, the economic well-being of citizens or residents of any given country. Thus, PPPs is the first step in the process of converting the level of GDP into a common currency to enable these comparisons to be made. Similarly, monthly PPPs used to derive the table are OECD estimates. The table is read vertically. Every column shows the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. It’s worth noting that the products included in the basket of goods and services used for the calculation of PPP are all samples of goods and services covered by GDP. A large number of products is used to enable countries to identify goods and services which are representative of their domestic expenditures. Explaining the difference in price levels In Australia (198-116) the price differences is explained by product differentiation and difference in tastes in between the two countries; this is the gradual change and advancement of quality of given goods in order to suit the targeted customer taste. This is greatly determined not only by the needs and tastes of customers but also the availability and longevity in existence of certain raw materials. Thus, the price of a given commodity is bound to change in accordance to the quality and star of the newly introduced or branded commodity. Therefore, this has an overall effect in the price of the of the basket of goods. In Canada(166-97) price difference can be explained by the exsistence of trade barriers- this basically depends on trading policies laid by different countries. In some come countries, there is huge rates that are charged to either import or export certain commodities. This policy have a great effect in the pricing of commodities by controlling the flux of commodities into or out of the country. United Kingdom(170-100) can be explained due to existence of non-tradable goods- some countries have large consumption and production of unreadable goods. Such goods result to wider variation of prices of relative to different countries. Government regulations; different countries have different policies regulating trade and overall economic activities. This is reflected in different price levels Germany(151-89),japan(155-91),Portugal(99-58) in Chile and United kingdom.The prevailingregulations in a given country havetremendous effectin the ultimate price of every or some of the commodities. This amounts to discrepancies in prices of similar commodities in different countries, all factors held constant. For example, the government in Chile might have imposed heavy taxation on sugar, this would obviously increase the price of sugar in that country. Since that particular commodity is featured in the basket of goods and services. It’s thus bound to result to different prices of commodities. In switzeIand (231-136) price differences can be attributed to input costs; it’s obvious that some products are cheaper to produce in given country and yet expensive to produce in the other country. This be due to among other factors, availability of raw materials and labor. This translates to different prices of similar commodities in different countries. Consequently, this is reflected in the overall pricing of good andservices as shown in this scenario. [In theory, the law of one price would hold that if, the Pesos in Switzerland were undervalued to be significantly relative to the in Chile thus merging gap to sustainable levels. In practice, of course, the basket of goods and services does not have a perfectly tradable good and there may also be capital flows that sustain relative demand for the either currency. Belowshows the comparative price levels for a representative basket of goods and services, expressed as the ratio of PPPs for private final consumption expenditure to exchange rates. The data above has been used in answering the above questions Reasons why investors are recently pulling out their funds from some emerging markets Political turmoil suchas protests in Thailand and Ukraine, has greatly demoralized and led to the exodus of existing investors. This has greatly decreased the influx of new investors in emerging markets such as Brazil and south Africa. The concern that emerging markets such as Indonesian economies haven’t reformed enough to sustain growth has also slackened the same. This has been worsened by the perfect storm of rising interest rate in the U.S. Low interest rates-most emerging markets allow investors to yield a small interest rates. This discourages and demoralizes not only potential investors but also the investors already on the ground. This hasled to investors pulling out and lettinggo (in the hands of other parties) there investments. This has ultimately incited a craze for risky bonds in fast growing economies. An example is Pimco’s (the world largest bond manager) flagship emerging market whose currency fund grew from one billion to twelve billion dollars over the last four years asinvestors, were in dire need of high yielding exposure to Brazil, Turkey among others showed the fund with cash. The same investors are currently pulling their money out of this and other emerging market bond funds. This is feared to ultimately lead to market tantrum that has devastative effects. The fluctuation of Turkish Lira and Argentina’s peso against the dollar has also been triggered by signs of weakness in the Chinese economy among others, this includes fears that it/they may eventually face a debt crisis. This has furtherbe worsened by edition of U.S federal reserves from its bond buying program. Therefore, a lot of money might end up exiting from various markets. It was confirmed by MSCI Emerging market index that,MSCIEF dropped nearly four percent over the last five trading days and such might be worsenedby the recent fall of street’s dramatic selloff. An example is the pulling out of $422 million retreat in the week ended January as stated in the Lipper, a Thomson Reuters company. Similarly,countries such as Brazilian and Indonesia have been running unattractive, discriminative and harsh policies that ends up discouraging and demoralizing investors. This has resulted to the pull out of existing investors in the emerging markets in fear of incurring losses. This has resulted to a decrease and a negative index of the investors in the foreign markets. An example is kubie”The Argentinian government has not been running attractive policies for foreign investors for a long time” The causes of currency crises; Currency crisis principally results from substantial decline in the value of a given currency. Such has been experienced in Brazil, Indonesia and South Africa. declineimpacts negatively on the economy by creating instability and surges in the exchange rate. This is due to relation between investor expectations and what those expectations result into. When the country has borrowedheavily, thatis; current account deficits. An example was southern Asian economies (The Asian Financial crisis in 1997-1998 that was triggered by Thailand’s decision to float its currency, after abandoning the peg to the dollar) that saw large increase in privately held debt, which was later bolstered in several countries due to super inflated assets. Similarly on December 20th 1994, the central bank in Mexico began converting short-term debt it no, denominated in pesos and, into dollar-denominated bonds. This conversion decreased foreign reserves thusresulting to mega debt that amounted to crisis. They often have to burrow to finance long projectsand public budget deficits. It’s also caused by political turmoil and uncertainty of the government’sactions, the results to making investors jittery. Such as assassination of Mexican presidential candidate in inMarch1994 that sparked off currency y fall off. Thiserodes theinvestors’confidence over the stability of that particular economy. They thus end up withdrawing their money out of that particular country in what is called capital flight. Such countries run into persistent current account deficits thus they import morethan they are exporting. Economic reforms can also lead to currency crisis such as it was experienced in late 1980s in Mexico when policies that were designed to limit the country’s rampant inflation were cracked. Such reforms as to which are likely to lower GDP in whatever fiscal year are dipterous. As it was experienced in India in its GDP dropped from 6.2 percent to 5 percent. Contagion and sunspots suchas exogenous shifts in in agent beliefs. This was recorded in Markova-switching regimes in the 1990s. High degree of real integration among emerging markets is a clear indicator of the magnitude of currency crisis in the American crisis. In summary, whereas fundamental factors—macroeconomic imbalances, shocks—are often identified as core causes of currencycrisis, numerous questions remain on the exact causes of crises. Currency crises sometimes tend to be driven by “irrational” factors. These are abrupt runs on banks, contagion and spillovers among financial markets, limits to arbitrage during times of stress, emergence of asset busts, credit crunches, and fire sales, and other aspects related to financial turmoil. Indeed, the idea of “animal spirits” (as a source of financial market movements) has long occupied a significant space in the literature attempting to explain crises (Keynes, 1930; Minsk, 1975; Kindle Berger, 1978).1 . The risk of ‘contagion’ in emerging markets from the recent happenings. Financial contagion refers to the scenarios in which small shocks thathad initially affected small or few financial institutions spread to the entire financial sectors and other countries whose initialeconomies were healthy. Brazilian, Indonesia and such emerging economies are at the risk financial contagion. Contagion is a consequential effect of currencycrisis. When various such crises are related to variousmonetary and financial sectors among other trade factors that amounts to contagion. For instance, Kaminsky and Reinhart (2000) recounts that trade links in goods and services compounded by exposure to a common creditor is not only liable to cause debt crisis but also an observed pattern of contagion. It can also amount from loopholes among financial instittutions.financial intermediaries provide generalequilibrium model to explain a small liquidity preference in a given region that can spread to others corners of the economy. This leads to ultimate contagion. It also emerges among from financial markets. This is as a result of correlation of information or liquidity channel. In this case, prices change in one market and this has ultimate effects in the values of assets and prices in the other markets.calvo(1999) argues that correlated liquidity shock channel that some market participants need to withdraw some of their assets to obtain cash maybe after experiencing any potential loss in the country. Such trends amount to transmission of shock. Lastly, geographical factor can also result to contagion as it was experienced in the Asian crises (1997)... on a light touch, trade links is a probable cause of the same but its effect is mostly mild. The Figure below shows the fall in the value of the Argentinian peso and the Turkish Lira against the dollar in January 2014. Currencies of other emerging markets such as Brazil, Indonesia, and S.Africa have also been experiencing bouts of volatility. The below information has been used to analyze the above questions; Discuss and evaluate the findings from the empirical studies on the CAPM debate. The CAPM debate describes the differences in risk premium acrossall assets. CAPM debate argues that, these differences are due to differences in the level of risk of the returns on the assets. It illustrates that beta is the correct measure of risk. Derivation of CAPM starts with a small problem of finding portfolio of assets for an arbitrarily chosen investor. R0to be the return (that is, one plus the rate of return) on the risk-free asset (asset 0). When one invests $1, the investor will get $R0.Assuming that the number of risky assets is n. Takeαifbe the fraction of the investor’s initial wealth that is allocated to asset if. Then RIis the return on asset if. .Rm be the return on the entire portfolio (that is, ∑in=0 αiRi).TheRi is a random variable with expected value ERi and variance var(Ri).The covariance between the return of asset i and the return of asset j is represented by cov(Ri,Rj). If the investor’s expected utility can be represented as a function of the expected return on the investor’s portfolio and its variance.Assume that the investor can choose to allocate wealth to three assets: i = 0, 1, or 2. Choosing fractions α0, α1, and α2 that maximize (1) V(ERm,var(Rm)) Subject to (2) α0 + α1 + α2 = 1 (3) ERm = α0R0 + α1ER1 + α2ER2 (4) var(Rm) = α21var(R1) + α22var(R2) + 2α1α2cov (R1, R2). The functionV is increasing in the expected return, ∂V/∂ERm > 0; decreasing in the variance of the return, ∂V/∂var (Rm) < 0. These indicates the trade-off between expected returns and the variance of returns. Substituting 1 – α1 – α2 for α0 in equation (1) and taking the derivative of V with respect to α1 and α2 yields the following conditions that must hold at an optimum: (5) (ER1–R0)V1 + 2[α1var(R1) + α2cov(R1,R2)]V2 = 0 (6) (ER2–R0)V1 + 2[α2var(R2) + α1cov(R1,R2)]V2 = 0 WhereVIis the partial derivative of V with respect to its jet argument, for j = 1, 2. Considering multiplying equation (5) by α1 and equation (6) by α2 and summing the results: (7) [α1(ER1–R0) + α2(ER2–R0)]V1 + 2{α1[α1var(R1) + α2cov(R1,R2)] + α2 [α2var (R2) + α1cov (R1, R2)]} V2= 0. Usingthedefinitions ofERm andvar (Rm), we can it as shown below; (8) (ERm–R0)V1 + 2var (Rm) V2= 0. Writing (5), (6), and (8) as explicit functions of the ratio V2/V1, and then the first two expressions [from (5) and (6)] can be equated to the third [from (8)]. This yields; (9) ERi – R0 = [cov(Rim)/var(Rm)](ERm–R0) (10) A portfolio appears on the mean-variance frontier of the variance relationship if no other choice of weights α0, αj (for j = 1, 2,n) yields a lower variance for the same expected return. While the portfoliois on the efficient part of the frontier if, noother portfolio is there when specifying the problem of a typical investor [in (1)– (4)]. If we drop this assumption (that the asset is not risk free) and set α0 = 0 from the start, then we obtain a slightly different relationship between return and risk than is this relationship: (11) ERi = Errs+ (ERm–ERz)βi WhereRz is the return on a zero-beta portfolio [that is, cov (Rz, Rm) = 0], Rm is the return on the market portfolio, and βi = cov (Ri,Rm)/var(Rm). providing an interpretation of beta in (10) or (11) as a measure of the asset’s contribution to portfolio risk. Taking a portfoliop of assets that earns return Rp and has standard deviation Sp = (var Rp)1/2. Let the standard deviation of an arbitrary asset i be Si and the covariance between asset i’s return and that of the portfolio be Ci,p. Considering a new portfolio with xi invested in asset i, –xi invested in the risk-free asset, and xp invested in the originalportfolio.Thatis,considermodifyingtheportfolio of an investor who currently holds xp in portfolio p by borrowing $xi and investing it in asset i. The standard deviation of the new portfolio is as follows’ (12) S = (x2iS2i + x2pS2p + 2xixpCi, p) 1/2. Note that the derivative of S with respect to xi is (13) Ds/dxi= (xiS2i + xpCi, p)/S. (14) Thisderivativemeasureshowmuchthe risk of the whole portfolio changes with a small change in the amount invested in asset i. (15) On evaluationof this derivative at xi = 0 and xp = 1, then we find thatds/dxi xi=0, xp=1 = Ci, p/Sp = (Ci, p/S2p) Sp= βiSp. Everyonein the economy will hold all risky assets in the same proportion on satisfaction of CAPM assumptions. Studies supporting CAPM; 1. Federal reserve bank of Minneapolis- this debates predicts that the ratio of the risk premium to the beta of every asset is the same. 2. Black; Black, Jensen and Scholes, Fama and Macbeth; It’s argued that this data describes the data, the model it is meant to expain and hence the historical average returns for various for various types of assets. It describes how CAPM measures the risk of investing in particular assets. Studies challenging it; 1. Banz; Famaand French-it questions the issue of the farm size.” Banz (1981) tests the CAPM by checking whether the size of the firms involved can explain the residual variation in average returns across assets. 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