This essay is a discussion of purchasing power parity theory and its usefulness in exchange rate determination. The essay is composed of broad three parts. The first section is a general understanding of purchasing power parity. The second section discusses some evidence from the literature regarding how forecasting exchange rates is difficult and how fundamental analysis does a poor job of it. The third section deals with a critique of purchasing power parity and why it may hold in the long run.
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Essay on Purchasing Power Parity (PPP) | Understanding PPP in Exchange Rate Determination
“The fundamental things apply; As time goes by.” -Herman Hupfeld, songwriter (1931)
The theory of purchasing power parity, though long debated, remains an important one in making cross-country comparisons and exchange rate determination. “Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.” (Dornbusch and Krugman, 1976). It is derived from the law of one price and indicates the equalization of prices of goods between two markets. Thus, purchasing power parity implies equalization of the price of a basket of goods between two countries. More formally, the theory of purchasing power parity states that the exchange rates between two currencies are the ratio of the price levels of the two countries. Apart from PPP, there are other theories of exchange rate determination such as conventional supply and demand analysis, Balance of Payments Theory, Monetary approach to exchange rate determination, etc.
How does PPP give us an exchange rate equilibrium? We will look at an example. If Ep/$ is the exchange rate that prevails on the spot market and if the basket of goods is cheaper in the United States. Then the PPP theory would suggest that this will lead to an increased demand for goods in the US market by Mexico. Thus the demand for dollars in the forex market goes up. Also, US exporters will realize that they can sell goods at a higher price in Mexico. Thus the demand for dollars by Mexican importers and the supply of pesos by US exporters goes upon the Forex market causing the exchange rate Ep/$ to rise.
Thus the exchange rate change occurred because of a difference in price levels in the two countries. But price level represents inflation rates, therefore, the theory suggests that if there is inflation in the US, the dollar would depreciate and the Mexican peso would appreciate.
The question of how exchange rates move and adjust has an important place in exchange rate policy, as it provides a ground to countries with fixed exchange rates and helps them know what the equilibrium exchange rate is likely to be. Countries with varying exchange rates would be interested in knowing the level and variance in real and nominal exchange rates they should expect so that the policies can be planned accordingly. It will help to view how exchange rates are determined via the fundamentals of the market, that is, supply and demand.
After the collapse of the fixed exchange rate system of Bretton Woods in the 1970s, the asset market approach developed wherein the financial markets determined the exchange rates in the short run, and the goods market (or PPP) via the market fundamentals determined the equilibrium in the medium run and long run. “Overall, the empirical evidence is not favorable to traditional economic predictors, except possibly for the monetary model 3 at very long horizons and the UIRP at short horizons, although there is disagreement in the literature” (Rossi, 2013). The literature suggests that long-run predictability of exchange rates might not be true. “… even the evidence of long-horizon predictability is not unshakeable … the exchange rate change may be forecastable over some periods, but that outcome may simply be luck. The current evidence of long-run forecastability might be overturned” (Engel, 2014)
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We can say that a model might work for one time period but not be relevant in another period owing to the rapid transformations in the financial markets and the random factors that influence trading decisions. Thus, relating the exchange rates to fundamentals is not a very good idea and instead, it should be viewed from a time series approach to exchange rate returns. The Purchasing Power Theory, therefore, does not seem to hold in the short run but it appears to be a good theory in the long run in explaining certain important features in the movement of exchange rates.
The PPP exchange rate can be viewed as a target towards which the spot exchange rates over these smaller time horizons converge. The empirical tests show mixed results but the usefulness of PPP as a long-run theory is more widely accepted than any other theory of exchange rate determination.
The Purchasing Power Parity, however, has been long critiqued for its inability to account for a lot of factors and oversimplifying assumptions. Let’s have a look at a few of them.
The PPP theory assumes that there are no transportation costs and no different tax structures in the two markets. However, this is a much unlikely proposition in the real world. Transport costs would make the exports cheaper and the imports expensive. Trade barriers such as import tariffs would raise the price in the import market. Thus it becomes difficult to equalize simply the prices of a basket of goods to determine the exchange rate.
The theory does not incorporate the costs of nontradable inputs. For example, the price of a Big Mac hamburger sold in the New York City center and in New York suburbs would be different and will never equalize. The rental charge in the City center is much higher which translates into higher prices. Note that there is no opportunity for arbitrage here owing to high transport costs. Thus the competition will never equalize the prices in the two areas.
The theory assumes that individuals have perfect information, however, this is not true in reality. In the real world, certain price deviations are known to some traders but not to others. Thus in case of a profit opportunity, traders without the information will not realize and prices won’t equalize.
Often there are other market participants such as expectations of profit-seeking importers and exporters that impact the PPP level of exchange rate. Thus it would rely on the current account of a country’s balance of payments. A tremendous amount of trade happens in Forex markets daily with the amount of transactions being much more than the amount of daily trade. According to the interest rate parity theory, the adjustment in exchange rates is motivated by the return-seeking nature of investors and since these investors trade in assets, this would impact the capital account of the balance of payments. Thus the exchange rates are often driven by investor motives and are not only caused by the actions of exporters and importers but the theory of purchasing power parity fails to take into account the changes in BOP.
PPP also finds its application in cross-country comparisons of GDP. An interesting example is the “Big Mac Index” developed in 1986 by The Economist. Since Big Macs are “sold in 41 countries, with only the most trivial changes of the recipe, should be a guide to whether currencies are trading at the right exchange rates.”
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Thus, in the context of Exchange rate determination, we can conclude that “the fundamentals apply, as time goes by”. However, how long this ‘long run’ is not defined but the theory of purchasing power parity, despite all evidence against it, does a good job of explaining the behavior of exchange rates in the longer run.
References
- Blanchard, O. (2009) Macroeconomics. 5th ed. Pearson Education.
- De Jong, Eelke. (1999). Exchange Rate Determination: Is There a Role for Macroeconomic Fundamentals? Economist. 145. 10.1023/A:1003181226305.
- Dornbusch, R. and Krugman, P. (1976) “Flexible Exchange Rates in the Short Run.” Brookings Papers on Economic Activity, pp. 537– 75.
- Engel, C. (2014) Exchange Rates and Interest Parity, in G. Gopinath and E. Helpman (eds), Handbook of International Economics, vol. IV, pp. 453-522, Amsterdam: North Holland.
- Krugman, P. Obstfeld, M. and Melitz, M. (2012) International Economics. 9th ed. Pearson Education Asia.
- Rossi, B. (2013) Exchange Rate Predictability, Journal of Economic Literature, vol 51, pp. 1063-1119.
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