Purchasing Power Parity

Purchasing Power Parity

Introduction

First referenced by David Ricardo in 19th century and popularized by Cassel in 1918, the theory of purchasing power parity has remained an important topic of debate over the last one century. In fact, the theory has received massive attention over the last one century, especially in macroeconomics.  However, there has been a debate over the validity of using this theory in macroeconomics, especially when considering its empirical applicability. Thus, the purpose of this paper is to evaluate the applicability of this theory in international arbitrate relationship. Arguably, too much attention is given to the notion of purchasing power parity. Whilst this parity condition is simple and intuitive, lack of empirical support means it has no value to either practitioners or macroeconomists.

The theory of purchasing power parity and its role as an international arbitrage relationship

Known as the PPP theory, it asserts that when the nature of exchange rates is fluctuating, the respective purchasing powers of two given currencies will fix the rates of exchange between them in the end and within their own nations. According to Sarno, Chowdhury and Taylor (2004), the theory bases its claim on the observation that the business and people because of its purchasing power in its own nation demand foreign currency in a given nation. Moreover, the domestic currency also holds some purchasing power because it has the potential to buy some amount of goods and services within the country of its origin (Hau 2000). Therefore, when there is an exchange between the domestic and the foreign currency, the domestic purchasing is exchanged for the foreign purchasing power. The implication is that there is an exchange between the domestic purchasing power and the foreign purchasing power. According to Taylor and Sarno (2004), equilibrium between the two purchasing powers is reached when the domestic purchasing powers of the two currencies are equivalent. This equilibrium is the exchange rate at which the parity between the purchasing powers of the two currencies (thus the two nations) should be maintained. This is the law of “one price”. According to Micossi and Milesi- Ferretti (1994), any change in the purchasing power of any of the two currencies causes a similar change in the exchange rate. Therefore, according to Krugman and Obstfeld (2009), this theory explains that the external value of a given currency depends on the purchasing power of the currency in its domestic market relative to the domestic purchasing power of the other currency.

For the law of one price to apply, a number of conditions must necessarily prevail. First, there must be a competitive market in both countries for both goods and services. Secondly, the law of one price is applicable only to the goods and services that can be exchanged through trade between the two countries in comparison. Finally, there must be a thorough checking of the transport expenses and other expenses on transaction because they normally hinder trading of goods and services between two nations.

According to Stockman (2007), two types of purchasing power parity emerged in the 20th century in macroeconomic terms. First, the absolute purchasing power parity is grounded on maintaining equal prices in both countries in comparison. Secondly, the relative purchasing power parity describes the rate of inflation. Here, the appreciation rate of a given currency is determined by calculating the difference between the rates of exchange of the two nations in question.

The role of purchasing power parity as an international arbitrage relationship has further become a topic of debate in macroeconomics. By definition, arbitrage is the act of buying and selling similar or relatively equal commodities simultaneously for the purpose of guaranteed amount of profits. The implication of interest rate parity for determination of the exchange rates has been explained in determining the role of PPP as an international relationship of arbitrage (Hau 2000). In this case, it is assumed that the forward exchange rate is unbiased, albeit roughly, as a predictor of the future rate. The relative interest rates and the expected future spot rates are used in determine the implications of exchange rate.

Problems facing PPP in practice and macroeconomics

Too much attention is given to the notion of purchasing power parity. Whilst this parity condition is simple and intuitive, lack of empirical support means it has no value to either practitioners or macroeconomists. Even in a single nation, it is evident that the activity of arbitrage remains costless. This means that the one price law will not apply. In fact, this law does not hold in normal conditions. The cost of transport as well as restraints that hold trade between the two nations in question causes differences in the cost of delivering commodities of trade, especially with differences between geographical locations (Murray & Papell 2004). Pricing is therefore subject to change due to the impact of differences in costs. Therefore, the costs of transport as well as the restrains to trade will cause deviations from the one price law. On the international scene, the differences are more viable than on local platform because the cost of transportation of commodities as well as the restrains to international trade has the potential to cause a significant deviation from the law of one cost (Murray & Papell 2004).

In fact, it is worth noting that in commodity trade, transportation cost is a potential barrier to effective exchange of goods and services. This is evident even on local trade. Countries with poorly developed transport and communication infrastructure as well as large countries such as Russia and China may feel the effect of massive deviations in prices from one place to another within the local market. Even in cases where transportation costs like shipping and insurance fees are available, there is evidence of limitation of arbitrage on divergence of prices. Although prices of commodities can differ with the cost of transport but without a significant consequence on trading, incentives are likely to arise for activities of arbitrage if the prices difference exceeds the cost of transportation (Murray & Papell 2004). If a comparison is made in domestic and foreign prices there is need to measure them within the limits of the same currency.

It is also worth noting that some goods and services experience extremely high costs of transportation relative to their market value.

Secondly, non-trade inputs affect the applicability of the PPP in macroeconomics terms, especially due to lack of empirical support for the theory. In this case, some non-traded goods act as inputs to the process of producing goods for trade. Moreover, it is difficult or quite expensive to transport some factors of production from location to another. The implication is that costs of inputs into the process of producing goods for trade will vary from one location to the other (Hau 2000). A good example of this phenomenon is the differing value of land between one location and another. For example, the differences between places like London or New York and Mumbai are significant (Murray & Papell 2004). While the cost of production could be almost similar between the three locations, the cost of land is relatively high in London and New York as compared to the cost of the same factor of production in Mumbai. In addition, it is not necessarily that a traded goods differ with locations (Murray & Papell 2004). In fact, when traded goods can easily be arbitraged, there will be limitations in the differences at difference geographical locations. This could have an impact on the profitability of production at different locations, especially in cases where the cost of input vary with geographical locations (Hau 2000).

Sercu,Uppal and Van Hulle (2005) argues that restraints to trade have also an impact on the applicability of PPP as an international arbitrage relationship. For instance, anything that may retard the spatial arbitrage of goods and services is actually a restraint to trading. For example, within a given nation, such factors could include prohibitions on provision of labor across boundaries or legal regulations that differ from one country to another. Such barriers as quotas, export duties and tariffs on imports act as international barriers to trade (Hau 2000). They enforcing of these barriers is effective in a given time, then they become a cause of divergence in foreign prices. Similar to the impact of changing cost of transportation in production and trade, tariffs have the potential to establish a band of divergence between the foreign prices and the domestic prices of goods and services.

Conclusion

From an in-depth analysis, it is evident that the impact of transportation cost, barriers to trade and imperfect competition and non-trade inputs significantly on trade between two nations significantly affect of the Purchasing power parity. In fact, they tend to provide evidence that  too much attention is given to the notion of purchasing power parity. Whilst this parity condition is simple and intuitive, lack of empirical support means it has no value to either practitioners or macroeconomists.

 

 

References

Harrod, R 2003, International Economics, Nisbet and Cambridge University Press, London.

Hau, H 2000, “Exchange Rate Determination under Factor Price Rigidities,” Journal of International Economics, vol. 50, no. 2, pp. 421–47.

Krugman, R & Obstfeld, S 2009, International Economics, Pearson Education, Inc, London.

Micossi, S & Milesi- Ferretti, GM 1994, Real Exchange Rates and the Prices of Nontradable Goods, International Monetary Fund, New York.

Murray, CJ & Papell, DP 2004, The Purchasing Power Parity Puzzle is Worse Than You Think, University of Houston, Houston, TX.

Sarno, L, Chowdhury, I & Taylor, MP 2004, “Non-Linear Dynamics in Deviations from the Law of One Price: A Broad- Based Empirical Study,” Journal of International Money and Finance, vol. 23, no. 1, pp. 1–25.

Sercu, P, Uppal, R & Van Hulle, C 2005, “The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity,” Journal of Finance, vol. 50, pp. 1309–319.

Stockman, AC 2007, “The Equilibrium Approach to Exchange Rates,” Federal Reserve Bank of Richmond Economic Review vol. 73, no. 2, pp. 12–30.

Taylor, MP & Sarno, L 2004, “International Real Interest Rate Differentials, Purchasing Power Parity and the Behaviour of Real Exchange Rates: The Resolution of a Conundrum,” International Journal of Finance and Economics, vol. 9, no. 1, pp. 15–23.

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