PURCHASING POWER PARITY THEORY AND EXCHANGE RATE
Table of Contents Purchasing Power Parity Theory and Exchange Rate 3 Overview of Purchasing Power Parity Theory 3 Purchasing Power Parity and the Law of One Price 4 Types of Purchasing Power Parity 6 Long Run Exchange Rate 6 Ongoing Inflation, Interest Parity, and Purchasing Power Parity 8 Strengths and Weaknesses of Purchasing Power Parity 9 Empirical Analysis of Purchasing Power Parity Theory 10 Factors Explaining the Problem with Purchasing Power Parity 12 Traded Goods 12 Non-Tradables 13 Deviations from Free Competition 14 Price Measurement Levels and Consumption Patterns 14 Purchasing Power Parity in the Short Run and Long Run 15 Conclusion 16 Reference List 17
Purchasing Power Parity Theory and Exchange Rate
No nation is rich enough to rely on free gold standard. All countries across the globe have paper currencies that are not convertible into other valuable things including gold. Hence, nowadays nations have standard paper currencies, which complicate exchange situations. In such cases, the exchange rate between two currencies can be determined by their purchasing powers. The purchasing power parity theory holds that the rate of exchange between two nations depends on their currencies’ relative purchasing power. In essence, the exchange rate between currencies of two nations equals the ratio of their price levels. The purchasing power parity, therefore, predicts that a decline in a currency’s domestic purchasing power due to an increase in domestic prices, will lead to a proportional depreciation of the currency in foreign exchange market (Paul, Kimata & Khan 2017).
Conversely, purchasing power parity holds that an increase in currency domestic purchasing power will result in a proportional currency appreciation. For instance, if a certain good can be bought for $1 in the United States and 60 rupees in India, the purchasing power of$1 in the United States equals to purchasing power of 60 rupees in India. If in the United States $1 can buy a collection of goods that cost 80 rupees in India, then the exchange rate will be $1 equals to 80 rupees. This report tests the validity of absolute purchasing power parity and relative purchasing power by comparing the prices of commodities in the United States and India, and the exchange rates between the two countries. What product you are comparing mention it as well ???
Purchasing power parity is a simple theory that states that the nominal exchange rate between different currencies is the same as the ratio of aggregate commodity price levels between the two nations. This way, the unit of currency of one nation has the same purchasing power in another country. This theory has a long history, dating back many years ago (Pilbeam 2013). The primary idea behind the theory is that a unit of currency ought to be able to purchase the same basket of commodities in one nation as the equivalent amount of foreign currency can purchase in a foreign country. Hence, there is parity purchasing power of one unit of currency across different economies.
The simplest means of determining whether or not there is a discrepancy from purchasing power parity is to compare the price of identical commodities from the basket in two different nations. For instance, the Economist newspaper normally compares the prices of MacDonald Big Mac hamburgers around the globe with the United States dollars at prevailing market exchange rates. By doing so, it is easy to determine whether or not a given currency is overvalued or undervalued against the dollar at prevailing exchange rate. For instance, in July 2019, a Big Mac burger was selling at £3.29 in United Kingdom against $5.74 in the United States, implying an exchange rate of 0.57. The variance between this and the actual exchange rate of 0.80, suggests an undervaluation of the British pound by 28.5 percent (Economist 2019).
The purchasing power parity holds due to international goods arbitrage related to the law of one price. This law asserts that the price of a globally traded commodity should remain the same anywhere around the world as long as the price has been expressed in common currency. This is due to the fact that people to earn riskless profits by moving commodities from areas where the price is low to areas where the price is very high. If the same commodity enters each nation’s market basket used to derive the aggregate price level, then the law of one price holds that a purchasing power parity exchange rate must hold between the two economies concerned (Lee & Yoon 2013). Proponents of purchasing power parity theory content that its validity as a long run theory does not necessarily need the law of one price to be exact.
Even if the law does not hold for each individual good, proponents of the theory contend that prices and exchange rates ought not to deviate too far from the relation determined by purchasing power parity. When commodities are more expensive in one nation than in other countries the demand for its commodities and currency declines, which pushes both the domestic price and the exchange rate back in line with purchasing power parity. Conversely, relatively cheap domestic products lead to appreciation of currency as well as price level inflation. Purchase power parity, therefore, holds that even if the law of one price is literally untrue, the resultant economic factors will eventually equalize the currency’s purchasing power in different nations (Krugman, Obstfeld, & Melitz 2012).
Opponents of law of one price posits that the presence of transaction costs such as transportation costs, tariffs, non tariff barriers, and taxes, would violate the law of one price. In addition, not all commodities are traded between countries and different countries do not attach similar weights to similar commodities in aggregate price indices. Moreover, different economies produce commodities that are differentiated instead of perfectly substitutable goods. Also, given that purchasing power parity is anchored on traded commodities, the law of one price can be effectively tested using producer price indices that contain the price of manufactured tradable goods instead of consumer price indices (Bahmani-Oskooee & Nasir 2015).
Notwithstanding the aforementioned objections, it is always held that the purchasing power parity theory of exchange rates holds due to international goods arbitrage. Generally, there are two means in which the purchasing power parity hypothesis might be true- absolute purchasing power parity and relative purchasing power parity (Liang 2013). Absolute purchasing power parity remains true when a unit currency’s purchasing power parity is the same in both the domestic economy and foreign economy, once the unit currency is converted into foreign currency at the current market exchange rate. Nonetheless, it is usually challenging to determine whether the same basket of commodities is available in different nations.
Hence, it is important to test relative purchasing power parity. Relative purchasing power parity posits that the percentage change in exchange rate during a given period of time offsets the variations in inflation rates between economies concerned over the same duration. Generally, if absolute purchasing power parity holds, the relative purchasing power parity must also hold (Zhang & Bian 2015). However, absolute purchasing power parity must not hold if the relative purchasing power parity holds because it is common for common variances in nominal exchange rates to happen at different purchasing power levels for the two economies (Findreng 2014). Mathematically, relative purchasing power parity between the United States and India is expressed as;
(E$/rupee, t – E$/rupee, t-1)/E$/rupee, t-1 = πe us-πe India
Where πe denotes the rate of inflation, πe = (pt-pt-1)/pt-1
The theory of purchasing power parity, when combined with money demand and supply relationship, leads to a significant theory of the interaction between exchange rates and monetary factors. Since the factors that do not affect money supply and money demand do not impact this theory, it is usually referred to as the monetary approach to exchange rate. This approach helps in understanding the long run theory of exchange rates (Al-Gasaymeh & Kasem 2016). The monetary approach to exchange rates is a long run rather than a short run theory due to the fact that it does not accommodate price rigidities, which help in understanding short run macro-economic developments. On the contrary, the monetary approach to exchange rate proceeds as though prices can adjust immediately to maintain purchasing power parity and full employment (Abbas Ali, Johari & Haji Alias 2014).
To derive the monetary approach to exchange rate predictions for dollar/rupee exchange rate, it is important to assume that in the long term, foreign market determines the rate so that purchasing power parity holds.
Rupee (dollar/rupee) = Price (USA)/ Price (India)————–(i)
It is assumed that the above equation should hold if there are no market rigidities to prevent immediate adjustment of exchange rates and other prices to levels that are consistent with full employment.
In the United States;
P (US) = Ms US/L(R$, YUS) ——————- (ii)
While in India;
P (India) = Ms India/L(R rupee,Y rupee)—————–(iii)
Ms refers to a nation’s money supply
L(R,Y) refers to a country’s aggregate real money demand, which falls with an increase in interest rates and rises with an increase in real output.
Equations (ii) and (iii) demonstrate how the monetary approach to exchange rate derives its name. The statement of purchasing power parity in equation (i) shows that the dollar price of rupee is the dollar price of the United States’ output divided by rupee price of India output. The two price levels are, therefore, determined by the supply and demand of each country’s currency. The United States’ level of price is money supply in the United divided by real money demand in the United States. Similarly, the price level in India is the Indian money supply divided by India’s real money demand. Hence, the monetary approach to exchange rate predicts that real exchange rate- the relative price of dollar and rupee- is determined in the long run by not only the relative supplies of those currencies but their relative real demand as well.
Although a permanent increase in a country’s level of monetary supply leads to proportional increase in its price levels, it does not pose any long run effects on interest rates and real output. Whereas a conceptual examination of a short run money supply change is important in determining the long run impacts of money, it is an unrealistic description of monetary policies. The reasoning is that continuing growth in money supply will need a continuing increase in price level or ongoing inflation. Other factors remaining constant, constant growth of money supply at a given rate leads to ongoing inflation of price levels at the same rate. Nonetheless, changes in the long run rate of inflation do not affect the long run relative price of commodities or full employment output level (Saadon & Sussman 2018).
The interest rate, nonetheless, is independent of long run growth rate of money supply. Whereas the long run rate is independent of the absolute level of money supply continuous growth in money supply will affect interest rate (Taylor & Sarno 2004). The interest parity condition holds that if people expect the relative purchasing power parity to be true, the difference between interest rates provided by rupee and dollar deposits must equal the difference between expected interest rates in India and the United States. The interest parity condition between the United States dollar and Indian rupee is expressed as;
R$ = R (rupee) +(E$/rupee- E$/rupee)/E$/rupee
(E$/rupee- E$/rupee)/E$/rupee=πe us-πe India
R$-Rrupee= πe us-πe India
If currency depreciation can offset the difference in international inflation, so that πe us-πe India is the expected dollar depreciation, the difference in interest rate is equal to the expected difference in inflation.
The primary strength of purchasing power parity is that it always remains stable over a long period of time. The relative purchasing power parity, in particular, proves that exchange rate should equal purchasing power parity in the long run. This can be attributed to a decline in rate of inflation between two countries. Nonetheless, conditions relating to prices and tariffs tend to change all the time hindering people’s ability to arrive at a stable conclusion regarding exchange rates. The purchasing power parity can only apply to a static world, but the world is dynamic. This is due to the fact that with time the exchange rate will rise will price level continue decline, leading to a situation where exchange rate is greater than price levels. Rose, Marquis and Lu (2012) indicate that internal prices and production costs are always changing. Hence, a new equilibrium between two different currencies changes on daily basis. Differences in two nation’s economic performance, especially in relation to transport and tariffs, can deviate normal exchange rates to certain levels from a currency’s intrinsic purchasing power. The exchange rate value of a country’s currency will rise while its price levels will remain constant if it decides to raise its tariffs.
Can u add more strength of PPP theory and more weaknesses of the theory as is an important part and has to be critically explained <<<<
Overall, the absolute and relative purchasing power parity theories do not effectively explain the relationship between actual data on exchange rates and price levels. Relative purchasing power parity, which is always considered a reasonable estimation to exchange rate data well for a given duration. An analysis of figure 1 demonstrates strengths of relative purchasing power parity by plotting the United States dollar against Indian rupee exchange rates, Erupee/$, and the ratio of India’s and the United States price levels, Pindia/Pus, between 2008 and 2018. Price levels are illustrated by indexes reported by both the Indian and the United States governments.
Relative Purchasing Power Parity
Relative purchase power parity predicts that Erupee/$ and the ratio of India’s and United States’ price levels will move proportionately, which is not the case. From 2008 to 2018, the Indian rupee gained significant strength against the United States dollar. In 2018, the exchange rate was 70.83, which was equal to the purchasing power price. This validates the relative purchasing power parity assertion that exchange rates and price levels in two economies should equal out after a given period of time. As the rate of inflation continued to decrease from 1.74 on January 1, 2008 to December 1, 2018, relative purchasing power parity also decreased from 133.68 to 70.83. Nonetheless, the relative purchasing power parity can only apply partially even if the long run understanding of purchasing power parity and exchange rate is taken into consideration.
More explanation needed about the graph 1 (exchange rate) add more information ) what happened ? what is the history behind that.. more critical evaluation
Figure 1: the Indian rupee/United States dollar exchange rate and India-U.S price levels between 2008 and 2018
1-You should add the deviation graph as well and explain it ?
2-what happened? 3-what is the history behind this increase during the last 10 year ? 4-and explain in details this graph what the deviation represent ? and relevant information related to this graph .. what does it show ? what are those number related to ppp ???
After you finish the relative theory part you have to say if the data we had in the real world is the same as the relative theory explains … even if is not the same its still fine but we have so say that ..
Absolute Purchasing Power Parity
To test the effectiveness of absolute purchasing power parity theory, it is important to compare international prices of a broad basket of commodities by making necessary adjustments for inter-country quality variations among the identified goods and services. These comparisons normally hold that absolute purchasing power parity is ineffective. The prices of identical goods, when converted into one currency, tend to vary across different economies. According to Çağlayan and Filiztekin (2012), even the law of one price is ineffective in explaining the relationship between purchasing power parity and exchange rate. For instance, manufactured commodities that tend to be the same in different countries normally sell at different prices. Since the assertion that leads to absolute purchase power parity is anchored on the law of one price, there is no doubt that purchasing power parity does not support the data. To understand the impact of absolute purchasing power parity, there is need to prices of traded and non-traded goods in different countries.
This part is not ok as the product I asked for traded goods is Vans shoes … and if you cant find Vans shoes data you can do Nike is still ok but has to be shoes company….
-in this part you are comparing the prices in the different country by doing the Big mac index the table you have done is not the same I sent you … you have to follow the table below and compare them in this way … and explain the numbers ???
-you should mention a small sentence of why we have chosen this product and these countries ?
-since the price of the product compared to the countries are in different currencies you should convert all the prices to US dollar in order to compare them .
-you should include the excel of the Big Mac index for the calculations you have to show me how u did the calculations and
This is the table local price of the product , exchange rate , dollar price , ppp, and the value the calculation has to be done in excel and here only the table …. Like this
The formulas to do this calculation are below :