Purchasing Power Parity - Essay Example

? Purchasing Power Parity Purchasing power parity is universally used to compare price level of different countries hence making it simple to understand and interpret data for every country. PPP’s goal is to help in identifying adjustments that should be made in the exchange rates of different country’s currencies and make them at equilibrium with the purchasing power of each other. The main idea behind the purchasing power parity is centered on creation of an expenditure of a particular commodity similar in both currencies based on the exchange rate (Adhikari, Guru-Gharana, & Flanagan 2011, pp. 3-7). PPP therefore means that the exchange rate between two countries is in equilibrium when the domestic purchasing power at that particular rate of exchange are similar in that, a bundle of goods in France should cost the same in the United States once the exchange rate is taken into account. This form of writing provides a deep analysis of Purchasing Power Parity and highlights some of the PPP’s significance in the economy. PPP theory is used in various situations including adjustments for the price differences between countries and provides the solution of comparing countries with dissimilar wellbeing standards as well as setting exchange rate for new countries. By comparing the value of output from different countries and considering exchange rate for ease of data comparison, a lot of information between countries can be obtained (Yavuz 2013, p. 118-121). PPP may make it easy to determine numerous things such as the speed at which the global economy grows and further determine a country, whose average persons are better off. Purchasing Power Parity exchange rate is one of the numerous techniques that can be used to convert different country’s statistics into a common currency (Carvalho & Nechio 2011, pp. 2412-2423). It is worth noting that the PPP exchange rate must not be similar with the one that prevails in the financial markets as it may either be more or less. Nevertheless, comparison of prices between different countries considers several products and services, which is a very complex task due to the massive amount of data, and the sophistications encountered in the process. In facilitating the price comparison process, always an International Comparisons Program (ICP) generates PPPs founded on global survey of prices where every participating country provides national average prices for several products. PPP is deemed a better measure of the overall wellbeing and its exchange rates are always fairly stable over time. Unfortunately, PPP is not easy to determine compared to other approaches such as the market based rates since ICP is a huge statistical undertaking and there are challenges of methodological involved such as estimation of the PPP rates that may lead to inaccuracies. Additionally, another challenge of using the PPP approach is that there are products that are never available in some countries thus limiting their utilization in comparison purposes. According to Adhikari, Guru-Gharana & Flanagan (2011, p. 4-8) because these countries share almost same economic trend of consumption normally experience better PPP exchange rates compared to countries that do not have similar economic characteristics. On the other hands, most of the developing countries particularly in Africa and Asia may make it difficult to obtain an adjusted exchange rate for PPP because they do not have well-kept economic records deemed important in determining the PPP exchange rates (Taylor 2009, 19-24). Although it may be presumed that, the nominal exchange rate and PPP may be comparatively similar there is always, an evident of a marked difference in the PPP’s accustomed exchange rates. It is significant to note that the PPP figures are normally grounded on the law of one price that indicates that products and services cost similar amounts everywhere such as the price of Big Mac in UK and France are similar. This assumption is vital in comparing the two products directly in order to obtain a PPP adjusted exchange rates between the two countries but if Big Macs is sincerely cheaper in one country, the outcome may be skewed. This would indicate that the law of on price does not apply in the adjustment of the PPP exchange rates; however, since PPP exchange rates are based on basket of goods the outcome do not normally have huge discrepancies (Yavuz 2013, p. 118-123). Moreover, being that the relative PPP uses the price index in determining the alterations in the equilibrium exchange rate, it borrows several drawbacks associated with the price index. PPP further neglects the demand and supply approach of the foreign exchange thus making it unsatisfactory since market forces are the key determinant of the exchange rate. PPP approach does not take into consideration the difference in quality of products and services from different nations and assumption of the significance of quality makes it look unrealistic (Wang 2009, pp. 32-37). There are also some unrealistic assumptions such as the absence of transport cost, perishable goods, location, and absence of any barriers to the international trade that makes the Purchasing power parity theory impracticable. PPP approach further abandons the effect of international capital flow, which may in turn lead to variation in the exchange rate. There were a number of studies held in 1970s that were meant to test whether continuous PPP hold and the outcome gave hope since the positive results gave evidence of a stable dollar amidst insufficient information to assess the approach (Carvalho, & Nechio2011, p. 2395-2409). Nevertheless, volatility of the dollar increased towards the end of 1970s as the data became more available to the econometricians. The econometricians later indicated that the initial approaches to the exchange rate were unsuitable. Exchange rates in the short run are always news driven and may be triggered by news concerning the changes in interest rates and perception of the growth path implying that PPP do not define it. According to Wang (2009, pp. 32-37), short run deviations from the PPP are normally huge, volatile and of the same order of magnitude particularly the price differential volatility which is surprisingly large. Many of the illustrations regarding the short-term exchange rate volatility are rooted in financial aspects including portfolio changes, short-term asset price bubbles as well as the monetary shocks, which may have substantial effect on the real economy. Because of the abject failure of “the law of one price” in microeconomic data, tests concerning aggregate price indices devastatingly reject the PPP within a short period. Botch of short run PPP has mainly been ascribed partly to adhesiveness in nominal prices. Researchers have concluded swaying suggestion that the real exchange rate would always incline towards PPP after a longer period (Taylor 2009, 19-24). Currently, the emerging consensus explain that in after some time (long run) PPP has contains certain rationality especially for the main exchange rates even though most puzzles are yet to be determined decisively. The extensively conventional restraints are a long-term impartiality constraint of nominal variables, which do not have long-lasting consequence on the ranks of real variables but do not rely on any particular monetary policy rule. According to Carvalho, & Nechio (2011, p. 2400-2409) the long run hypothesis rely on an assumption underlying nearly all the monetary macroeconomic model although long run neutrality is not empirically valid since there are insistent long run effects on real variables by nominal shocks. Differences in both the national spending and the current account imbalances are regarded as variables affecting both the short run and the long run deviances. Equilibrium of real exchange rate may change for various reasons in the long run such as wealth effects and productivity effects (Rogoff 1996, pp. 647-653). It is worth noting that the recognized assessment for evidence of the PPP as a long run phenomenon is basically based on a realistic check of the real exchange rate. When real exchange rate is settled at a position aligning with PPP, it displays reversion towards its own mean and this is a necessary condition for long run PPP. Purchasing Power Parity Puzzle The purchasing power parity puzzle entails both the high short run volatility of the real exchange rates deemed to be illustrated in monetary and financial shocks and the slower speed of adjustment to the PPP indicating slow compatibility with explanations (Rogoff 1996, p. 647-652). In investigating the characteristics of the real exchange rates as well as the tenacity of their deviances from PPP, scholars utilize impulse response analysis and half-life to determine the period taken for the response to a unit shock to disintegrate by half (de Carvalho, M. & Julio, P 2012, pp. 727-737). The literature has worked towards an advancement of various results obtained by applying a number of procedural advances, however most researchers have singled out the partiality evolving from unsuitable assembling of cross sectional units that resulting into unfairness of the half-life upwards. Study of the development of the exchange rates between 1970s and 1980s excluded the law of one price and PPP as equilibrium condition amongst developed countries during the time of floating exchange rates. The rejection is known in the works, as the PPP puzzle and most of the factors affecting the real exchange rates are believed to be unexplainable to some extent by just mere explanations. Taylor & Taylor (2004, pp. 135-146) argues that the existing solutions to the PPP puzzle entails econometric clarifications that emphasis on the lesser influence of the linear time series methods, which are significant in testing PPP. This kind of feature assumes that the pragmatic denial of long run PPP is just an arithmetical misapprehension that intends to improve PPP tests of greater power thus making various studies to utilize durable samples as well as panel data procedures that make results extra favorable to PPP (Rogoff 1996, pp. 650-659). Nevertheless, they have not escaped econometric criticisms thus resulting into PPP validation in her relative instead of the absolute PPP, which results into unsolved variances amongst the price levels whose measurements are based on common currencies. PPP’s long run failure has further led to development of theoretical arguments where one group of explanations include shift in relative demand as well as relative productivity (Adhikari, Guru-Gharana, & Flanagan 2011, pp. 3-7). It is evident that the challenges emerging from the definition of half-life and proposal of better definitions are very critical and the weakness arises due to the focus on the instant notion of half-life. Bibliographies Adhikari, D., Guru-Gharana, K. & Flanagan, J.L 2011, "Comparing Two Exchange Rate Regimes Under Purchasing Power Disparity", Journal of International Business Research, vol. 10, no.,1, p. 1-10. Retrieved 25 December 2013, . Carvalho, & Nechio, F 2011, "Aggregation and the PPP Puzzle In A Sticky-Price Model", The American Economic Review,Vol. 101, No. 6, Pp. 2391-2424, Retrieved 25 December, 2013, . de Carvalho, M. & Julio, P 2012, "Digging out the PPP hypothesis: an integrated empirical coverage", Empirical Economics,vol. 42, no. 3, p. 713-744, Retrieved, 25 December, 2013, . Mankiw, N 2009, Principles of Macroeconomics, Mason, OH, South-Western Cengage Learning. Mankiw, N 2012, Brief Principles of Macroeconomics, Mason, OH, South-Western Cengage Learning. Rogoff, K 1996, The Purchasing Power Parity Puzzle, Journal of Economic Literature, vol. 34, no. 2, pp. 647-668, Retrieved 25 December, 2013, . Taylor, Alan & Taylor, M 2004, The Purchasing Power Parity Debate, Journal of Economic Perspectives,vol 18, no. 4, p. 135–158, retrieved 25 December, 2013, . Taylor, M 2009, Purchasing Power Parity, and Real Exchange Rates, London: Routledge. Wang, P 2009, The Economics of Foreign Exchange and Global Finance, [Berlin], Springer-Verlag. . Yavuz, C 2013, "Testing Validity of the Purchasing Power Parity: Evidence from MENA Countries", The Business Review, Cambridge, vol. 21, no 2, pp. 118-125, Retrieved 25 December, 2013, . Read More