Issues and Problems with Purchasing Power Parity - Essay Example

INTRODUCTION: Purchasing Power Parity (PPP) is one of the mostly used economic concept in order to analyze and understand the economic conditions of different countries and the relative elements between different international economies. The concept of Purchasing Power Parity (PPP) is used in order to determine the amount of money required for purchasing the same goods and products in two different countries and as a result to calculate the foreign exchange rate. The main concept behind the Purchasing Power Parity (PPP) theory is that the prices associated with commonly used products and goods among different countries should be similar once converted in the common currency (Abuaf and Jorion, 1990). Purchasing Power Parity (PPP) theory tends to relate the exchange rates and the price levels. The theory provides the ratio which reflects the relative differences in the level of price in two different countries for same products or goods. Purchasing Power Parity (PPP) is the first step in the process of comparing the countries in term of Gross Domestic Product (GDP) and the other related elements or components (Taylor and Taylor, 2004). In this report and attempt has been made in order to understand and explore the concept of Purchasing Power Parity (PPP), it implications, and the issues associated with the Purchasing Power Parity (PPP) theory. THEORY OF PURCHASING POWER PARITY (PPP): The theory of Purchasing Power Parity (PPP) has started from the basic concept of law of one price and have evolved into different concepts like absolute Purchasing Power Parity (PPP) and relative Purchasing Power Parity (PPP). Law of One Price: The basis or ground of the main Purchasing Power Parity (PPP) theory is directly related with the law of one price. According to the law of one price the price or cost of any product which is being traded in different countries should have the same price in different countries after adjusting and converting to a common currency, ignoring the additional costs associated with tariffs, transportation, and taxes. For example, the price of one mobile phone is PMUK in United Kingdom and PMUS in United States, then according to the law of one price (Taylor and Taylor, 2004): PMUK = E * PMUS Where E is the exchange rate between the currency of United Kingdom i.e. Euro and currency of United States i.e. dollars. Hence, the price of mobile phone will be similar in both country if converted into one currency. Absolute Purchasing Power Parity (PPP): The concept provided by the law of one price for one product can be easily applied to the group of products and prices. For instance the same concept can be applied to the common basket of goods which can be traded across different countries, the price associated with this common basket of goods is known as the Consumer Price Index (CPI). In this way one can compare the overall prices in United Kingdom and United States, which is given by the equation (Taylor and Taylor, 2004): PUK = EUK/US * PUS According to the theory of Purchasing Power of Parity (PPP), the above equation can be modified in order to obtain the form of absolute Purchasing Power Parity (PPP) (Taylor and Taylor, 2004): PUK / PUS * 1 / EUK/US= 1 Or, PUK / PUS = EUK/US The EUK/US is the real exchange rate between the both countries. Relative Purchasing Power Parity (PPP): The same concept can be applied for controlling the constant price differential in different countries and measuring the relative Purchasing Power Parity (PPP). This in turn allow to compare different basket of goods. The changes in the relative exchange rate among different countries are directly associated with the changing inflation rate in different countries. The relative Purchasing Power Parity (PPP) can be presented as follow (Taylor and Taylor, 2004): (EUK/US)2 – (EUK/US)1 / (EUK/US)1 = IIUK - IIUS Or, % change in EUK/US = % change in PUK - % change in PUS PRICES AND EXCHANGE RATES: It is important to analyze and explore that is there any direct relationship between the price levels and exchange rates as depicted by the theory of Purchasing Power Parity (PPP). Different economists and analysts have established the point that there is direct and strong relationship between the exchange rates and prices. As shown by the Purchasing Power Parity (PPP) theory that in long run the price level determines the exchange rates between different currencies. The value of any currency is calculated on the basis of the level of prices and inflation in the particular country in relative to other countries in the world. Most of the economists use the theory of Purchasing Power Parity (PPP) in order to explore and determine the differences in the level of prices and exchange rates among different economies and countries (Taylor and Taylor, 2004). ISSUES AND PROBLEMS WITH PURCHASING POWER PARITY (PPP): There are several issues and problems associated with the theory of Purchasing Power Parity (PPP) (Adler and Lehman, 1983). However, these issues and challenges are not big enough to void the validity of the Purchasing Power Parity (PPP) theory. Some of the factors which cause issues and challenges for the theory of Purchasing Power Parity (PPP) are as follow: Cost Associated with Transportation: According to the law of one price and theory of Purchasing Power Parity (PPP) it is important to ignore the costs associated with the transportation of the goods and products are not included and ignored while calculating the similar price and exchange rates. However, it is not possible to ignore the transportation cost as the process of transporting products from one place to another results in incurring considerable amount of expense. This in turn will result in the creation of high divergence while comparing prices (Taylor, 2009). Tariffs and Taxes: Another assumption made by the theory of Purchasing Power Parity (PPP) is to ignore the tariffs and taxes. However, if the tariffs and taxes are ignored it will result in providing inappropriate values for the exchange rate and relative prices. Different countries have different level of tariffs and taxes imposed on the trade of goods and services. This in turn directly impact the level of prices and thus exchange rates. Hence, this assumption of theory of Purchasing Power Parity (PPP) to ignore the tariffs and taxes make the final results void (Pesaran, Smith, Yamagata, and Hvozdyk, 2009). Costs Associated with the non-tradable Products: The theory of Purchasing Power Parity (PPP) has one major flaw that it does not take into account the cost associated with the products which are not traded and obtained from the local market. At the same time there is clear difference between the prices and costs associated with different operations like sales and marketing. This in turn will also directly affect the final price of the product. Also, the prices and expenses of utilities are different in different countries thus directly affecting the composition of the final price of the product being traded and marketed in both countries. Apart from this, different countries have different level of wages and salaries. Hence, different goods and elements which are not tradable have direct impact on the determination of the final prices of the products or goods being marketed in different markets. Some other related elements in this regard is of change in the level of productivity, government spending, and current account deficits in different countries across the world (Koukouritakis, 2009). Information Asymmetry: Another assumption on part of the law of one price and theory of Purchasing Power Parity (PPP) is that all investors are provided with similar access to different information associated with the prices in different markets and regions. Because of this availability of the similar information any investor can take advantage by making profits by selling the goods at relatively higher price until the market is again in equilibrium because of the action of market forces. However, if the investors are not provided with the proper and similar information then there will be no action on part of the investors and associated with market forces thus disturbing the whole system. It is difficult and almost impossible to provide investors with the same information and data (Chang, Lu,Tang, and Liu, 2011). Pricing to Market: Another element which directly challenge the validity of the theory of Purchasing Power Parity (PPP) is the ability of the organizations to provide the products at different prices in different countries according to the specific market dynamics and factors. Organizations tend to charge different prices in different countries on the basis of the local scenario and situations. Apart from this the market forces and certain regulations in different countries force the organizations to charge different prices as compared to prices in other countries and regions (Bergin and Feenstra, 2001). CONCLUSION: Different economics and research analysts have been exploring and analyzing the theory of Purchasing Power Parity (PPP) and associated implications. It is universally believed that the theory of Purchasing Power Parity (PPP) is an effective and efficient method to understand and determine the exchange rates among the currencies of different countries. Despite of the fact that there are several flaws with the basic theory of Purchasing Power Parity (PPP) but still it is viewed as strong and beneficial technique for exploring and analyzing the overall economic situation and condition of different countries all over the world. The researchers and economists should be aware of the limitations associated with the theory of Purchasing Power Parity (PPP) and should take necessary steps and measures in order to overcome these limitations and using the theory in effective and efficient manner. REFERENCES Abuaf, N., and Jorion, P. (1990). ‘Purchasing Power Parity in the Long Run.’ Journal of Finance, 45(1): 157-174. Adler, M., and Lehman, B. (1983). ‘Deviations from Purchasing Power Parity in the Long Run.’ Journal of Finance, 38(5): 1471-1487. Bergin, P., and Feenstra, R. (2001). ‘Pricing to market, staggered contracts, and real exchange rate persistence.’ Journal of International Economics, 54(2): 333-359. Chang, T., Lu, Y., Tang, D., and Liu, W. (2011). ‘Long run purchasing power parity with asymmetric adjustment: further evidence from African countries.’ Applied Economics, 43(2): 231-242. Koukouritakis, M. (2009). ‘Testing the purchasing power parity: evidence from the new EU countries.’ Applied Economic Letters, 16(1): 39-44. Pesaran, M., Smith, P., Yamagata, T., and Hvozdyk, L. (2009). ‘Pairwise tests of purchasing power parity.’ Econometrics Review, 28(6): 495-521. Taylor, A., and Taylor, M. (2004). ‘The Purchasing Power Parity debate.’ Journal of Economic Perspectives, 18(4): 135-158. Taylor, M. (2009). ‘Long run purchasing power parity and real exchange rates: introduction and overview.’ Applied Economic Letters, 16(1): 1-4. Read More