The Purchasing Power Parity Theory THE PURCHASING

THE PURCHASING POWER PARITY THEORY

by Student’s Name

Code + Course Name

Professor’s Name

University Name

City, State

Date

The Purchasing Power Parity Theory

Introduction

This paper critically evaluate the purchasing power parity theory as a model of exchange rate determination. The essay discusses the purchasing power parity theory, it criticism and how it explains the evolution of sterling pound to dollar rates.

The purchasing power parity theory is said to have originated in Salamanca school in Spain in the 16^thcentury. The concept of purchasing power parity is based on notion that currencies have a purchasing power and hence the exchange rate between two currencies will be the ratio of aggregate price level between two countries[CITATION Ala04 \l 2057 ].Meaning that the purchasing power of a unit of currency will be equal between the two countries that is if someone converts the domestic currency into the foreign currency the amount of goods that the foreign currency will purchase in that country will equal to the amount of good the domestic currency would have purchased in the domestic market before the conversion. This means that the arbitrage opportunities should not exist where by one can buy good at lower price in one country and sell at a high price in the other as such opportunities will lead to increased demand of goods and currency of the country with low prices adjusting the prices to equilibrium hence the PPP model is based on the law of one price. Though the reference to purchasing power parity theory was made by Riccardo, the theory was popularized by Gustav Kassel after the First World War in 1918[ CITATION Gau10 \l 2057 ].After the World War I there was a debate on the nominal rate of currency exchange among the industries nations due to the widespread hyperinflation that occurred during and after the war. Some countries had abandoned the gold standard in 1914 when the War started and these countries were experiencing different inflation levels to those that maintained the gold standard. So of the countries that had abandoned the gold standard were willing to switch back to the gold standard. These developments led to the need of developing a way to determine the exchange rate between different countries. Gustav Cassel suggested the purchasing power parity model as mean of adjusting exchange rates or parities to those before the First World War for the countries wishing to return back to the gold standard[ CITATION Rob02 \l 2057 ].Although only a very few economists believe in purchasing power parity theory explanation of short-term exchange rates most believe the PPP model can explain the long run exchange rates[ CITATION Ken96 \l 2057 ].Though the theory was initially proposed to determine the exchange rates it is currently also used to compare the living standards of different countries.

There are two version of the purchasing power parity models which include the absolute and relative models.

Absolute Model

This is the simplistic model of purchasing power parity theory and is based on a multi-product version of law of one price but in a global setting[ CITATION Cor11 \l 2057 ].According to the absolute purchasing power parity theory, the rate of exchange should generally mirror the relationship between the internal purchasing power of the different countries currency units. The theory claims that the exchange rate should equal the ratio of price of a set of goods in one country to that of the other country. The absolute PPP theory assumes that there are no trade barriers, transaction cost or even transportation costs availing arbitrage profit opportunities in case of disparities in price levels.

The equation for determining the exchange rate using the purchasing power parity theory is;

Rate of exchange (R) between country A and B = [units of currency A / units of currency B] * internal purchasing power of A /* internal purchasing power of B

The internal purchasing power of each currency is substituted with the reciprocal of the general price index as the internal purchasing power is the inverse of price levels.

R= [units of currency A / units of currency B] * [general price index in country B/ general price index in country A]

Further the units of currency are substituted with set of commodities since it assumed that the units of currency can purchase identical basket of commodities.

R= [Q0 / Q0]*[PB/PA]

Where R is the rate of exchange, Q0 is corresponding weights of commodities in basket, PB the price index in country B and PA the price index of country A.

The absolute purchasing power parity has it weaknesses such as the assumption of free trade, lack of transportation costs and transaction cost between two countries. It has been described as too simplistic and unrealistic in it assumptions. Another shortcoming of this theory is it attempts to measure the purchasing power in absolute terms instead of more correctly relative terms.

The Relative Purchasing Power Parity Theory

The relative version of the purchasing power parity model postulate that changes in price levels in can be used to explain the changes in the equilibrium rate of exchange between two currencies. The theory associates the variations in the equilibrium exchange rates to variations in the purchasing power parities of currencies. Meaning that, the comparative changes in the price levels in two countries between some specified period or the base period and the current period influences the rates of exchange between the two countries ‘currencies in the current periods. The relative version of PPP states that the equilibrium rate of exchange in the current period (R1) is determined by the equilibrium rate of exchange in the base period (R1) and the ratio of price indices of current and base period in one country to the ratio of price indices of current and base periods in the other country. Expressed as;

R1= RO* [PB1/ PBO] / [PA1/PA0]

Where R1 is the current rate of exchange between currency A and B, RO is the specified base period rate of exchange, PB the price index in country B and PA the price index of country A.

Apart from having unrealistic assumptions such as absence of transportation costs, the relative model of purchasing power parity theory suffers from the problem of determining a base exchange rate which is in equilibrium because if that is not the case the current and future rate of exchange determined using the model will all be wrong.

Criticism of the Purchasing Power Parity Theory

The purchasing power parity theory is one of the most discussed theory in economics field and has been criticised and scrutinized in equal measure by various economists. Some like Keynes have dismissed it as a trivial truism or untrue due to it strong assumptions which are unrealistic in the practical world. For example the assumption that there are no barriers to trade, absence of transportation costs, transaction costs, insurance and taxes are too unrealistic. It is well known that not only in foreign trade some of the assumptions of PPP theory could not hold even in the domestic market. Such assumptions include absence of transportation costs.

The PPP theory presumes that there is a direct functional association between the price levels of two countries or the internal purchasing power of their currencies and the rate of exchange. In reality, such a direct relationship between the purchasing power of the two currencies and the rate of exchange does not exist. It is evident that rate of exchange is influenced by other factors besides the purchasing power of the currencies. These other factors are overlooked by the PPP model.

The PPP theory determines the rate of exchange by comparing the indices of general price levels in the two countries or the changes in general price levels for the relative model. As the general price level includes both the prices of domestically and internationally traded goods, the PPP model is based on the implied notion that the prices of these two categories of goods vary equally and proportionately in the same direction in both the countries. However it observed that it not the case in most of the time making that assumption invalid. The critics of this assumption suggested that only the international mobile and traded goods be the only one include in calculation of price indices but these proposition was dismissed by Keynes saying that such change would make the model meaningless.

One of the main criticism against the PPP theory is concerned with the use of price- indices as a mean for measuring the purchasing power of currencies in different countries. The main problem with price indices is selecting which one to use as they are several price indices in each country. Another difficulty with price index is that they are a sample of commodities which represent the basket of goods consumed in that country which may not be a true representative of the national commodities basket. Also different countries have different consumption patterns making it difficult to constitute the said national commodities basket as the commodities may not be comparable. Different countries uses different method of constructing price indices such as use of different base year, different weight and averaging methods[ CITATION Ala \l 2057 ].It is hence a difficult or impossible task to construct a price index that represent the accurate measure of purchasing power parity of a currency.

The PPP theory suggestion that there is a causal relationship between change in price level and the change in exchange rate has been criticised as invalid. The critics of the PPP theory it is possible that changes in exchange rates can cause changes in price level rather than change in price level causing the change in exchange rate. This is true especially for countries which relies on international trade for example when the domestic currency depreciates the price of imports will increase pushing up the price levels hence the preposition by the PPP theory is faulty and misleading in this case.

The PPP theory is criticised for overlooking capital transactions and only considers trade of merchandise. The theory can be applied to only those nations that merchandise trade account the BOP is constituted only by the merchandise trade account. Kindelberger was critical of the PPP theory saying it was designed for countries who trade only but not for those countries which trade and bank (receive capital inflows). The assumption of zero capital movements between countries is critiqued as being too simplistic and invalid as capital inflows and outflows are important components in balance of payments and cannot be simply ignored. The impact of large capital flow in developing nations on their exchange rates are well know as they tend to cause or intensify volatility of exchange rates[ CITATION Raq12 \l 2057 ]. Additionally it argued that prices of commodities are not the only factor driving demand and supply of merchandise commodities but also the expectation of exchange influences the people decision on whether to trade and in what direction[ CITATION Mic84 \l 2057 ].

The relative PPP theory is based on assumption that the base rate of exchange was in equilibrium which can be wrong making the whole model wrong despite the price level changes calculations in the two countries being correct[ CITATION Smi18 \l 2057 ]. This is persistent problem since any other rate of exchange base on that the base exchange rate will be wrong causing a permanent error. It is also difficult to identify and determine an exchange rate which is in equilibrium.

The PPP theory is condemned for being a static theory which assumes many factors will remain constant over time which in reality is not valid as most factors changes with time. Some critics of the PPP theory states that the assumption of no structural changes in the factors which underlie the equilibrium in the base period are misleading. They state that such factors as tastes or preferences, productive resources, technology, market sentiment and other disturbances will usually occur. The assumption related to constancy barter trade terms between two countries is another invalid assumptions since barter trade terms between two countries will vary from time to time due factors such demand and supply variation of foreign goods and foreign loans[ CITATION SNI18 \l 2057 ].

Keynes argues that the PPP theory fails to consider the elasticity of reciprocal demand and only uses the changes in relative price. He claims that the elasticity of reciprocal demand is an important factor in determination of rate of exchange. The other factor that is disregarded by the PPP theory is the influence of market forces of demand and supply on rate of exchange. The main cause of changes in exchange rate can be directly associated with supply and demand of the currencies and these forces are influenced by other factors besides the relative price levels. These other factors may include capital flows, cost of transaction, population change, technological changes and even government intervention. The PPP theory has also overlooked the impact of income and expenditure on the rate of exchange through affecting the demand and supply of goods. For example price levels in the high income countries is higher than those in low income countries. These variations in income and expenditure are ignored in the PPP theory. The Penn-Balassa-Samuelsson effect states that there high correlation price levels and income levels of economies[ CITATION Phi11 \l 2057 ]. Ragnar Nurkse claims that treatment ofdemand simply as a function of price, excluding the large variation in the aggregate income and expenditure which occur in the business cycle (due to either forces of demand and supply or government intervention)[ CITATION VAn18 \l 2057 ]. This canlead to wide changes in the volume of trade hence affecting the value of foreign trade even if prices or price relationships are constant.

The PPP theory is built on the assumptions of free international trade and laissez faire. These notion is clearly incorrect as it is common practice for government to intervene in both international trade and domestic trade through actions such as taxes, licencing, quotas and other measures that regulates and control trade and other transactions. The theory is therefore based on wrong assumption which are far from the reality. The theory can only serve as crude estimation of equilibrium rate of exchange with it unrealistic assumption and cannot empirically measure the rate of exchange. Also it cannot be used in predicting the rate of exchange. The theory is fundamentally wrong when it is followed strictly and loses its value when not strictly followed[ CITATION Rud85 \l 2057 ].

The theory is also critiqued for not recognizing the basis on which international trade is built. The theory assumes that both countries can produce similar commodities and can consume similar commodity which is fundamentally wrong as there would be no motivation to encourage international trade between countries. The international trade is based on comparative advantage and geographical specialization in trade. In addition the theory fails to recognize change in international trade relationships such entrance of another trading partner of existence of multiple trade partners and just looks at two trading partners. The PPP theory is therefore too simplistic to determine the rate of exchange in a complex trading relationship including several countries.

The dependence of PPP theory on law of one price suffers from the fact that not all goods are internally tradeable some goods cannot be exported or imported. For example Samuelson claims that he cannot import cheap haircuts from Paris neither export beautiful scenery Niagara falls to Europe[ CITATION Pau64 \l 2057 ]. The tradeable good affects the price levels but do not provide arbitrage opportunities for example it is difficult although not impossible for someone to relocate to a place or a country which has a lower price level. Perfect competition may be necessary for price parity to be observed which also may not always be the case. Presence of imperfect competition is relevant to failure of PPP theory as it make it difficult for perfect arbitrage of price to occur. For example monopolies or oligopolies may employ tactics such as price discrimination in segmented markets[ CITATION Pap05 \l 2057 ]. Other factors such as different demand patterns also affect the basis of law of one price for example demand for bacon is high in Germany but low or non-existent in Saudi Arabia.

The PPP theory implies that the real exchange rates do not affect the growth rate of economies which has been criticised as evidence exist to reject this implication and it well know that the exchange rates indeed affect the long run growth rates[ CITATION Joã00 \l 2057 ].

The purchasing power parity theory is said to be only relevant in estimation of long-term rate of exchange but cannot explain the short run exchange rates variations. This is due to monetary disturbances in the short run period. It failure to explain either the short-term volatility of real exchange rate or the excessive persistency[ CITATION Yin00 \l 2057 ]. Taylor claims his empirical finding provides evidence that in long run the PPP theory is valid andmoney appears to be neutral at that horizon; however, the short run variations can be large and are closely related to monetary shocks suggesting a role for nominal rigidities[ CITATION Ala00 \l 2057 ].

Empirical Studies on the Purchasing Power Parity Theory

The purchasing power parity theory has been extensively studied with differing conclusions from various scholars. Some have dismissed the theory and concluded that it does not hold while other have claimed that the theory closely explains exchange rate in the long run but not in the short run. The empirical test to scrutinise the PPP hypothesis has been mainly focused on three are which are;

To test whether the law of one price hold true for all traded commodities and whether it is possible to construct price indices which the law of one price can hold. The studies by[ CITATION Pet77 \l 2057 ]suggest that disregarding transportation and other costs the law of one price is obeyed by goods which are homogenous or close to being homogenous.However, for goods with little differentiation or those that lack close substitutes the law of one price did not hold and it was difficult or impossible to construct price indices that observes the law of one price. Ritchey (2009) found that wine did not obey the law of one price between Hong Kong and New York[ CITATION Kel \l 2057 ]. However he found out that the price differences in wine were diminishing in long run an indication thatlaw of one price may be valid in the long-term rather than in the short run. The law of one price is also rejected by Barzel who claims that price conveys both explicit and implicit information and that their price can differ due to implicit information or subjective view of customer toward a brand or reputation making the law of one price invalid since people are will to pay different prices for identical goods due to brand reputation[ CITATION Bar07 \l 2057 ].Barzel postulates that price variations of a commodity will decline as information about it quality becomes available. Another empirical testing of law of one price between countries found that most goods between any two European countries were either overvalued or undervalued even after adjusting for income and value added taxes differences, hence dismissing the law one price proposition[ CITATION Mar05 \l 2057 ].

The next area of the PPP theory is it parameters and have been extensively studied to estimate the estimated general equation of theory and test it parameters to those predicted by the PPP model. Studies indicates that the test of model fails to agree with the model itself in short run but they closely matches the model estimates in the long run[ CITATION Ken96 \l 2057 ].The findings Pippenger and Philips suggests that the law of one price works in commodity markets and any evidence that real exchange rates have long half-lives is a result of either using price indices of non-identical goods or testing the hypothesises in market where price arbitrage is not possible.[ CITATION Joh \l 2057 ]. The price level parity theory is found to be deficient in that countries with low income tend to have low prices for the non-tradeable goods such as rent, wage rate and other services while high income countries these goods will have high prices. Since the price indices are constructed as average of both consumed goods it include both the tradeable and non-tradeable goods, this inflates the price level of high income economies and deflate those of low income economies[ CITATION Irv83 \l 2057 ].

The last issue empirically tested on the PPP theory is whether it is an efficient predictor or determine of exchange rate. This area has generated much debate as different scholars has come up with conflicting conclusion with some supporting the valid while other rejecting the PPP model. The theory was found to hold in studies pacific islands countries using floating regimes[ CITATION TKJ14 \l 2057 ].The study by Mohammed indicates that PPP is valid in the long run and there is evidence a causal relationship between Algerian exchange rate and major world currencies[ CITATION Kam15 \l 2057 ].

PPP Theory Explanation of the Evolution of Sterling Pound to Dollar Exchange Rates

The PPP implies that the ratio of price level or rather the rate changes in price level between two countries determines the exchange rate between the two currencies. The PPP theory can for example explain the cause of GBP/USD to fall to it lowest level in 1985. Using the PPP model we can explain the drastic fall GBP/USD exchange rate to higher price levels changes in US in the years preceding 1985 due economic stimulation by Reagan administration. After high inflation in 1979 to 1980, prompted the government to intervene so as to curb inflation and control price level hence the great changes in the price level between the 1980 and 1985.

Conclusion

The PPP theory has it shortcomings and the criticism against this model are valid. But just like most theory strong or unrealistic assumption does not derive it theoretical validity. The PPP theory is still relevant and can be used to explain the long term exchange rates. Additionally it has become a useful tool for policy makers to compare the relative prices levels between different countries.

References