Do We Expect the Purchasing Power Parity Theory to Hold in the Real World - Literature review Example

Do we expect the PPP theory to hold in the real world? Discuss. Contents Contents 2 Introduction 3 Discussion 3 Conclusion 7 References 8 Introduction Purchasing Power Parity (PPP) is a well-known theory which states that currency is immaterial in deciding the purchasing power an individual has while purchasing something. The theory, though, doesn’t imply that exchange rates are constant. For example, 1dollar is selling at INR 60 in India currently and this may vary over time. The theory says that there is an interaction between exchange rates and prices and so if any item is selling at 1 dollar in the US it will also sell for INR 60 in India at that point in time. It implies that the real rate of exchange is always one which means that items purchased in the domestic market can be exchanged for a foreign item. Discussion Purchasing Power Parity is not likely to hold in the real world because of a number of reasons. These include the facts that international arbitrage is not possible because of the non-tradability of many goods and the various transportation costs. International arbitrage is not possible in the real world scenario because of the fact that there is no availability of perfectly substitute goods in different countries (Ickes, 2006, p.8). PPP may not be implemented in the real world in the short run because the consumers in different countries display different tastes and behaviours. The use of price indices which is done to draw a comparison between the price levels of goods in two different countries may not be accurate as the price indices in different countries are derived from a different portfolio of goods (Macdonald and Bayoumi, 1998, p.88). Therefore, it cannot be expected that the prices in separate countries behave in the same way, especially in the short run. The use of the price indices is not accurate as the movement of the prices of separate goods in the portfolio may be different. The change in price level of the index induces change in the individual prices as well. In the real world, inflation cause the prices of different goods to rise but the relative prices don not necessarily changes in the same proportion. Certain prises change at a more rapid rate and the change in then exchange rates are majorly affected by the changes in the relative prices of the goods. Thus strongly contradicts the theory of PPP because the PPP equation does not seem to hold in the real world in the short run. The exchange rates are influenced by the economic events occurring in the real world. Exchange rate fluctuations need to be considered even when the average price levels remain constant (Obstfeld and Rogoff, 1996, pp.14-20). Since the theory of PPP is based on the terms of real events and the price indices, therefore even when the price indices remain stable, the economic events like exchange rate fluctuations are likely to cause deviations in the PPP (Sarno, James and Marsh, 2012, p.78). The theory of PP assumes that different goods can be traded across the globe. But in real world scenario it is not possible to trade many goods across countries. For example goods and services like housing and medical services cannot be traded internationally. If the price of the non-traded products and services change, then it also influences a change in the price indices (Taylor, 2002, p.212). But in this case, the exchange rate may not change because the fluctuating price of the non-traded goods is not likely to influence the international trade flows. Therefore, the exchange rates are not likely to change in the long run which is contradictory to the theory of PPP. Another factor is that the developed countries have price levels which are higher than those in the poor or non-developed economies (Pilbeam, 2006, p.90). Also the price levels may vary among the different cities of a country based on the economic position of the individual state. For example, the rich cities in the United Sates tend to set higher price levels than the poor cities there. The reason for this is that the wealthy nations maintain the prices of the non-traded products and services at a higher level. For example, the price level of medical services in the United States of America is higher than in Turkey. The two major factors that decide the relative prices of goods are technology and income. A high income signifies more demand for the non-traded goods and thus the relative prices become higher. Technology highly facilitates the growth of the traded goods sector which causes lesser supply of the non-traded goods, But the demand for non-traded goods remain high. Therefore, because of the demand supply disequilibrium the relative prices of non-traded goods are increased. This is indicated in the Balsa Samuelson effect. Therefore the differentials in productivity may have link to the deviations of PPP which is not considered in the theory. Therefore, PPP is not likely to be applicable in the real world in the long run as well. The theory may be intuitively appealing but it doesn’t really have any practical application in the real world. It basically relies on the arbitrage opportunities. Arbitrage opportunities refer to the opportunities of buying items at lower prices in some place and selling them at higher prices in the other. Prices tend to converge as the buying activity in one country push prices up in that country and the selling activity in the other country push prices down in that country. But this seldom happens in the real world because of the existence of trade barriers and transaction costs which limits the price convergence via market forces (Cuddington and Liang, 2000, pp. 753-757). Moreover it is difficult to take the benefit of arbitrage opportunities because it is very difficult to transport products and/or services across boundaries at no cost. Transaction costs arise from taxes, transport costs, tariffs, nontariff barriers and duties. The PPP model was developed by G. Cassel in the year 1920. It is basically based on the one price law. The law assumes an efficient market which is hard to find in the real world (Reidel and Szilagyi, 2005, pp. 74-81). While formulating real rates of exchange for various countries, it should be noted that real exchange rates should only be affected by the macro variables which are real such as capital to labour ratio, or by any technical progress (Engel, 2000, pp. 253-263). Any change in real rates of exchange should not be accounted for by the nominal variables because by taking real rates of exchange the level of fluctuation in price has already been eliminated. The concept allows one to determine what should be the exchange rate between the currencies of two countries so that the exchange is on par with the purchasing power of currencies of the two countries (Papell, 2002, pp. 59-64). The Purchasing Power Parity theory serves two main purposes. The exchange rates of the Purchasing Power Parity are very useful to make comparisons between two or more countries because of their nature to stay constant for a longer period of time and only change a little when seen on the basis of year to year (Kanas, 2006, pp. 123-128). Moreover, exchange rates tend to move in the direction of PPP rates of exchange over the years and so it provides the direction in which the exchange rate may move in the long run. It also facilitates to make comparisons of income internationally because of the fact that market based exchange rates are often considered volatile. Market based exchange rates are also affected by financial and political factors which doesn’t lead to a change in the income immediately and this leads to a systematic understatement in the standard of livings in the poorer countries (Lothian and Taylor, 2000, pp. 759-764). The exchange rate calculation that is used in the PPP theory is often termed controversial because of the absence of “baskets of goods” that are comparable. Purchasing power parity is also difficult to estimate because countries don’t differ simply in terms of uniform levels of price. The difference in the prices of housing may be greater than the differences in food prices. People living in various countries tend to consume “baskets of goods” that are different. So it becomes necessary to compare the costs using an index of price. This is even more difficult because the goods that are purchased and the purchasing patterns differ widely across countries (Murray and Papell, 2002, pp. 7-12). So it becomes necessary to make some adjustments for the differences that are there in the quality of services and goods. It must also be noted here that the “baskets of goods” which is representative of only one economy will vary a great deal from that of the other economy. Conclusion Since, in real world scenario, currencies and exchange rate fluctuations have major importance, it can be identified that the theory of PPP is difficult to be applicable in the real world scenario. But PPP theory is considered as an important and relevant theory because of the simplicity and intuitive factors underlying the theory. Also the PP theory is considered a critical theory because the nominal exchange values tend to move towards the PPP values in a long period of time which is applicable in the real world scenario as well. References Cuddington, J. T. and Liang, H. 2000. Purchasing Power Parity over two centuries? Journal of International Money and Finance, Vol. 19, 753-757. Engel, C. 2000. Long run PPP may not hold after all, Journal of International Economics. Vol. 57, 243-273. Ickes, B. W. 2006. Lecture Note on the Real Exchange Rate. [Pdf]. Available at http://econ.la.psu.edu/~bickes/realex.pdf. [Accessed on 15 February 2014]. Kanas, A., 2006. Purchasing Power Parity and Markov Regime Switch. Journal of Money, Credit and Banking, Vol. 38, No. 6. Lothian, R. and Taylor, M. P. 2000. Purchasing Power Parity Over Two Centuries: Strengthening the Case for Real Exchange Rate Stability. Journal of International Money and Finance, Vol. 19, 759-764. Macdonald, R. & Bayoumi, T. 1998. Deviations of Exchange Rates from Purchasing Power Parity - a Story Featuring Two Monetary Unions. London: Routledge. Murray, C. and Papell, D. H. 2002. The Purchasing Power Parity Persistence Paradigm, Journal of International Economics, February 2002, 1-19. Obstfeld, M. & Rogoff, K. 1996. Foundations of International Macroeconomics. Cambridge: MIT Press. Pilbeam, K. 2006. International Finance, 4th Edition. Basingstoke: Palgrave. Reidel, D. and Szilagyi, J. 2005. A biased view of PPP. Cambridge: Harvard University Press. Papell, D. H. 2002. The Great Appreciation, the Great Depreciation and the Purchasing Power Parity Hypothesis, Journal of International Economics, Vol. 57, 51-82. Sarno, L., James, J. & Marsh, I. 2012. Handbook of Exchange Rates. New Jersey: John Wiley & Sons. Taylor, M. 2002. The Economics of Exchange rates. London: CUP Read More