Essay on Purchasing Power Parity

The PPP (Purchasing Power Parity) hypothesis illustrates the relationship which exists between prices and exchange rates in the economy. PPP can be categorized into absolute PPP and relative PPP. Absolute PPP is where purchasing power parity is defined as the ratio of two countries price levels. On the other hand, relative PPP, in a base period, the product of the stated exchange rates, is a ratio of the price indices between countries. The testing of this theory began in 1970 and has continued since due to occurrences such as the development of the economic theory. To apply PPP, we have to know the conversion factor that is used in the transfer of data when dealing with different currencies. In the account’s framework, this data ranges to high expenditure from the GDP. With PPP and its theories such as the mainly index- number theory, and comparison of inter-country GDP, data conversion can be highly boosted. (Dept., 2020)

Even though PPP is not supported by any economists, it has many supporters who use it in the case of calculating exchange rates. PPP also involves equilibrium exchange rates. An unmanaged exchange rate system is a form of short-run equilibrium exchange rate. In the case where the fixed exchange rate would produce balances of payments at equilibrium, we refer to that as long-term equilibrium exchange rate.

Problems Facing the Verification of Purchasing Power Parity Hypothesis

Assumptions

The PPP hypothesis makes a number of unlogic assumptions which becomes a problem. As due to these assumptions such as there does not exist transaction costs, this hypothesis does not hold. This is because in an economy where transaction costs exist, real exchange rates deviate from the PPP which causes a fluctuation in how international goods move. Not all goods and services can be traded internationally. This is a problem as PPP is under the assumption that all goods and services can be exchanged internationally.

Trade Restrictions

As stated earlier, the purchasing power parity hypothesis should be maintained at an equilibrium state. In some countries, trade restrictions are unadorned making a country to participate in more exports than imports. This causes the country’s currency exchange value to go above the PPP. This becomes a limitation in the verification of the PPP hypothesis. (Coakley, Flood & Taylor, 2004)

Speculation

Speculation in a market is where traders hold back goods in anticipation for a rise in the prices in the future. Traders may also dispose all goods at once in speculation that prices may fall. The exchange value of a country is supposed to be at per with the PPP. In the case where a country’s currency does not support speculation in the foreign exchange market, in the case of speculation, the exchange rate falls below the PPP making it difficult to verify this hypothesis.

Government Intervention

When the government intervenes in the foreign exchange market, by putting up tariffs and setting prices for imports; prices bid up rising above the PPP in the case of foreign exchange. This is because the government wants to benefit from foreign exchange by getting funds for government expenditure. This makes the verification of the purchasing power parity hypothesis difficult.

Relativity in Prices

Prices may change relatively in a country. This indicates changes taking place in the economy. This causes a deviation from the set foreign exchange rate to the relative PPP.

Inflation

In the case where the inflation of a country increases, the purchasing power of a country’s currency reduces. This forces a country to reducing their selling price below the real price of goods. This in turn lowers the country’s currency exchange value in the foreign exchange market below the PPP. This variation makes it difficult to verify the effectiveness of the purchasing power parity hypothesis.

Cost of Transport

There exists a difference in how imported goods are sold and those that have been produced locally. This brings about varying transportation costs. For imported goods, the cost of transportation is high while the cost of transporting locally manufactured good is low. Since countries have to consider this while importing or exporting goods, a fluctuation exists in the foreign exchange market causing a rise in the exchange rate above the PPP. This variation makes it difficult for the purchasing power parity hypothesis to hold as there does not exist an equilibrium state.

Capital Movements

Capital is the available resources and funds which are used in starting a business or a production of goods and services. The use of a greater percentage of the available capital causes a fall in a country’s currency purchasing power. This decrease in value causes a relative decrease in exchange rate value causing a fall below the PPP. The absence of a state of equilibrium makes it difficult to verify the effectiveness of the purchasing power parity hypothesis.

Taxes

Each country taxes its citizens. This is one of the ways in which the government gets its income which is used in projects that would benefit every citizen. Tax rates vary from country to country. This difference in taxes regulates what countries would charge at their borders in the case of either exports or imports. An increase in taxation increase the value of goods and services both locally and internationally. As a result, the exchange rates in a foreign market rise above the PPP. This makes it a problem to test the validity of the purchasing power parity.

Non-Profitable Services

These are services mainly offered by the government as they are essential but non-profitable. The government uses funds received from taxation. This causes an imbalance in the economy as capital is used but there is no profit received. This causes the value of currency in the foreign exchange market to fall making it unprofitable for exports. As a result, the exchange rates fall below the PPP. This becomes a problem as due to absence of an equilibrium state, it is difficult to verify the usefulness of the power purchasing parity hypothesis.

References

Dept., I. (2020). The Purchasing-Power-Parity Theory of Exchange Rates: A Review Article. Retrieved 17 December 2020, from https://www.elibrary.imf.org/view/IMF024/15467-9781451956436/15467-9781451956436/15467-9781451956436_A001.xml?language=en&redirect=true

Coakley, J., Flood, R., & Taylor, M. (2004). Purchasing power parity and the theory of general relativity: the first tests. Retrieved 17 December 2020, from https://www.cass.city.ac.uk/__data/assets/pdf_file/0008/29078/Purchasing_Power_Parity.pdf