PurchasingPower Parity (PPP)
Theconcept of Purchasing Power Parity is commonly used in economicplatforms to refer to the exchange relative value of one’s countrycurrency in comparison to another country currency based on certainparameters or commodities. In economic aspects, the purchasing powerparity is the estimated exchange rate of two different currenciesbased on the purchasing power of the currencies in the respectivecountries. In an economic perspective, the purchasing power parity isassumed to be the relative equal purchasing power that two differentcurrencies can buy goods for instance, the amount in dollars andequivalent value of Euros that could be used to buy a bottle of beer.
Thepurchasing power parity theory is used to make an estimation oncurrency conversion. Therefore, using the PPP hypothetical rates, agiven value of the currency has the same purchasing power of a givengoods another currency of a given country whether converted directlyto the value of that currency or used at PPP rate to buy the samegood. The PPP rate approach has been on the use for decades as a wayof reducing unreliable rates of currency value exchanges when makinginternational comparisons. Exchange rates fluctuate constantly anddifferently in different countries.
Therefore,when making comparisons of one country GDP to another based on theproduction of same value of goods, one country may rank lower thanthe other when their currencies are compared. However, if the PPPrates were used, there would be no difference in the productionlevels of GDP (Tim 3).
Criticalanalysis of the concept of purchasing parity
Theconcept has its origin in the 18thcentury from the works of Gustav Cassel. The theory has its basis onthe law of one-price that postulates that, in the absence of tradebarriers and transaction costs, the value of similar goods would havethe same cost value at different markets if the prices are convertedto the same currency. The theory is also called the ‘inflationtheory of exchange’ as a result of basing its argument on the pricelevel as a determinant of currency value in a given country(Cassel 98).
Thedifferent change in inflation rates of a particular product betweentwo countries locally and abroad is seen as been equal to thepercentage of appreciation or depreciation in the exchange rate. ThePPP is functional in that it serves as an important comparisonbetween two countries because of the near stability in the estimationrates. It has also been assessed that the normal exchange ratefollows the PPP exchange values in determining the shift in exchangerates. Any deviation from the purchasing power parity of a givenproduct means that the PPP rates need to be adjusted this adjustmentis done using the international dollar exchange rate. The PPP ratehas never been exact and deviations from the real exchangerates(Krugman90).
PurchasingPower Parity (PPP) vs. Quantity theory of Money (QT)
Historically,the PPP theory shares the same economic assumptions as the Quantitytheory of Money (QT). Just like QT theory, the PPP exchange ratehypothesis has been faced by numerous debates on its ability to makeaccurate conversions(Rogoff164).Just like the Quantity theory of money (QT) failed to hold as astandard measure of exchange rate during hyperinflation, likewisemonetary changes leads to a great deviation from what PPP wouldmeasure. In the same way, when there is changes in finance or incomethere is a significant change in the direct relationship betweenprices and money supply and deviation from the PPP. As such, onlyproductivity differential growth between two countries would serve asa true exchange rate. For instance, considering the price of onecommodity at home and abroad in foreign and home currencies at acertain exchange rate (i.e. American Dollar), the PPP versioncorresponds the ‘law of one price.’ If the prices of the saidgoods are translated in equal currency prices, like the dollars, andtheir quantity leveraged, the PPP will be same.
PurchasingPower Parity (PPP) and Big Mac
Thereis valid empirical evidence on the effectiveness of the PPP rates. Inparticular, as Chris recently argued on his article ‘Beer Index,’one can estimate the costs of trips overseas by the price of thecommonly drank beer worldwide, there is some evidence that PPP ratesestimates are effective(Taylor & Taylor 140).For instance, beer prices vary across the world, the cost of thecheapest beer in Warsaw is $1.00 or 79 euros, the same cheapest bearis five times more costly in Oslo and Tokyo this can be used tomeasure how cheap or expensive a given city is(McGinnis 2).The same argument was postulated by Big Mac Index when it wasinvented in 1986 as a means of gauging the ‘correctness’ of thecurrencies(Balassa 15).
TheBig Mac Index lays its basis on the purchasing power parity (PPP)theorem. Its main argument was that, the purchasing power ofdifferent currencies could be measured against the price of theburger in any given two countries. For instance, a burger cost $4.62in America while the same burger cost $2.74 according to January2014. In this regard, the Chinese Yuan could be said to have beenunderestimated by 41% compared to the dollar.However, thisburgernomics has never been precise in gouging the exchange rate ofcurrencies but only a leveraging perspective of understanding theexchange rates(Pakko& Pollard 8).
TheBig Mac Index has been used and recognized as a global standard overyears. One fallacy of this index is that it cannot accurately be usedas a leveraging platform of gauging the exchange rates a burger costless in China or other poorer countries due to cheap production coststhan developed countries (Pakko& Pollard 18).The difference in prices, therefore, cannot serve as a leveraging ofcurrent exchange rate between the two countries. In addition, the BigMac theory bases its argument on one-consumer product which may notbe identical in all countries due to other factors in its productionprocess. For instance, a burger is made from various agriculturalproducts and labor which varies from one country to another and,therefore, cannot be relatively reliable to make PPP of currenciesbetween two countries(Cassel 102).In another illustration, if the Canadian Dollar were overvalued basedon the Big Mac Index price, it would be unnecessary to buy the costlyburger at home than it is traveling to U.S to buy the same burger.The purchasing power parity leads to excess money that can be used tobuy other goods.
Alternatively,this would increase the value of Canadian dollars which in turn wouldenable them purchase the U.S dollars to purchase the burger thiswould in turn bring down the Canadian Dollars supply which isdetrimental to the economy (Krugman95).The leveraging ground would be subsidizing the price of the burgersat Canadian stores to bring the exchange rate to equilibrium. Theoverriding aspect is that Big Mac is not an ideal exchange rate indeciding the PPP difference in prices of the same products indifferent countries could be attributed to other factors such asproduct production differentials and government regulations(Taylor& Taylor 139).
Itis evident from the above hypothesis that there exist great fallaciesin using commodity prices as a standard measure of gauging currencypurchasing power parity. Besides these methodological issuesassociated with exchange rate assessment on basket of goods, PPPvalues do vary statistically from one country to another. Forinstance, the International Comparison Program, which utilizes thetenets of PPP, requires that countries disaggregate their nationalincome in GDP production, income and expenditure(Rogoff 37).
However,not all countries follow this criterion. In the same note, sometenets of PPP comparisons are doubtful. One cannot arguably compareindividual incomes and certain products in two countries as a tenetof PPP. For instance, there is no commercial practicality incomparing a worker in Chad who uses the teff and a worker inSingapore who eat rice rice is not readily available in Chad whileteff is not readily available in Singapore. The inference is that theprices of the commodities will vary significantly between the twonations(Taylor & Taylor 143).
Therefore,there is a need for adjustment of GDP on the value of transactedgoods in contrast to non-transacted goods between two countries inorder to reflect the collect exchange rate when using GDP to assessthe PPP. Another measurement issue in regard to PPP based on currencyis that, currency values fluctuate since they are used to trade otherassets/services other than produced goods. Therefore, cannot act astandard measure of PPP currency is used to buy real estates, stocksand other non-tangible goods which have the effect of changing thecurrency value(Balassa18).
Likewise,government intervention in the financial markets through hedgingpolicies, interest rates have for long affected the currency exchangerate. The general result of these changes is that, GDP becomes anunreliable basis of the measure for PPP between countries. Forinstance, if the Kenyan shillings falls by half compared to thenormal U.S dollar exchange rate, based on the above argument, GDPalso falls in the same measure in Kenya. As such, the effectivenessof PPP becomes effective adjusting this arbitrariness in estimatingthe exchange rate using the GDPs and basket of goods. PPP help togive more accurate estimates of exchange rates especially whengovernments manipulate the exchange rate (Krugman88).
TheLaw of One Price
Thebasic tenets of this law are that, identical goods should have sameprices for instance the value of a certain measure of gold should besame whether in Cairo, Zurich or South Africa expressed in Dollars.However, there exist unseen forces that may not conform to this lawone is that, there is no delineated way of selling a particularproduct and consumer preference varies from one country to anotherleading to arbitrariness of equality prices. In addition, transactioncosts, methods and competitions vary from one country toanother(Krugman89).
Thelaw of one price is touted as effective in controlling arbitragetrading in the financial market. Unlike other government imposedregulations on trade transactions, the law of one price requires nosuch regulation as itself regulate the price of the product in allmarkets. The law postulates that it is possible to have identicalprices of goods in two different countries without economic orgovernment barriers(Cassel 98).
Inaddition, this law postulates that it is the market participants whoeliminate difference in prices thereby leading to a common price(Taylor& Taylor 140).For instance, if goods are priced high in one area than the other,assuming that there is no government barrier or other economicbarriers, all sellers will move to sell their goods to the highpriced area leading to low supply and high prices in the otherlocation. In turn, this will reverse the process as sellers taketheir goods to their original location conversely this will still bethe case with consumers(Pakko & Pollard 11).The overall effect of both incidences is that, a single-price resultin the two areas(Rogoff 34).
However,this law presents salient difficulties in assessing the PPP inexchange rate(Lamont& Thaler 198).One is that commodity prices vary in different times in the samemarket. Second is that, the law cannot apply in cases where customerslack information on where to get goods at cheaper prices and thatsome firms will sell goods infrequently(Ong 143).Lastly, the law of common price is not applicable for somenon-tradable goods at international level for instance labor andland. In this regard, the PPP and the law of one price vary in that,while the laws of one price apply to single commodities the PPPrelate to general price value(Rogoff 38).
Thebasic relationship rests on the argument that, when the law of oneprice relates to most commodities then it conquers with the tenets ofPPP. However, if the price of law does not apply even to a singlecommodity, the validity of PPP cannot be measured in relation to thisaspect as PPP price estimates may not differ much. In general, thetenets postulated by the law of one price, relates to theperspectives of The Big Mac. Currency exchange rate estimation madethrough the law of one price and the commodity prices cannotjustifiably be a standard measure of PPP(Lamont & Thaler 199).The overriding argument is that, there exist salient forces whichrender the pricing mechanism unreliable leading to a wide disparityin PPP (Taylor& Taylor 146).
Thepurchasing power Disparities
Theefficacy of the PPP is based on an assessment of various issues.Deviation from PPP may be based on structural issues in the manner itresponds to changes in the equilibrium price levels(Cassel96).In some instances, disparities from PPP may occur in a transitorymanner from the economic disturbance which adjusts the differentialprices of goods in the market (Ong143).Thesedeviations may arise due to such factors as differential terms oftrade between two countries that alter the trade patterns (Rogoff34).Secondly, growth in the economy in any one given country alters therelative prices in that country the tradable goods (Rogoff64).Thirdly, changes in monetary and exchange rates may lead totransitory disparities in real price ratios as given by the PPP dueto such aspects as imperfect prices and flexible wages(Taylor& Taylor 142).
Structuraldisparities in PPP
Thestructural disparity in PPP could well be illustrated using theRicardo theory that, ‘the exact prices of goods are high in themanufacturing home country,’ and that ‘price levels are high inborrowing nations.’ In AN illustration, consider the Ricardiantheory and the tenets of one price on goods traded at home country,in a normal market the competition, the prices of goods relate tolabor costs (Cassel99).In this case, any uniform rise in the productivity of tradable goodsat home country would bring about appreciation or rise in therelative prices at home (Pakko& Pollard 15).
Thebasic explanation is that, applying the theory of one price on thetraded goods, increased productivity of the traded goods leads tohigh wages for the production of the goods thereby raising the wages.There is little or no productivity profits in the traded goods athome, but the prices, and costs of the goods rise thereby raising therelative price level of the particular goods(Lamont & Thaler 194).Other factors such as changes in technology, consumer tastes andpreferences, labor supply growth and certain commercial policies havethe effects of altering the relative price margins which consequentlychanging the real exchange rates(Rogoff74).
Therefore,as Ricardo productivity theorem postulated, real factors have animpact on the disparity of PPP.For instance, increased demand in homecountry goods significantly raises the wages and reduces the range ofmanufactured goods in that country to satisfy the rising demand(Krugman89).As such, the rise in productivity and wages leads to changes in thelevel of the relative price at home country. Consequently, as wagesrises also spending raises leading rising in the relative price ofthe said country(Ong 143).Empirical evidence indicates that the prices of primary tradablegoods in different locations are influenced by arbitrariness. Inaddition, evidence indicates that PPP does not always apply inuniformity for all manufactured goods(Taylor& Taylor 140).
Itis practically possible that, the price of identical goods do deviatefrom time to time due to other economic and non-economic factors asinformation and transportation costs that make arbitrarinessdifficult. In particular, regular adjustment in exchange rates leadsto changes in relative prices compared to the effects of changes inprices and wages (Lamont&Thaler 192).For instance, in normal trading, the relative prices of a given goodin a country may change due to arbitrary market practices such asauction versus normal selling. In auction prices changes constantlyand this might affect the PPP while in normal selling prices tend tobe constant (Cassel88).
However,even when the prices of tradable goods remain sticky, deviations arestill observable in the PPP. Prices of tradable goods do not alwaysremain sticky in the market due to changes in labor contracts andoligopolistic pricing of commodities. Firms make decisions on thepricing of their goods based on the production costs in that industrywhich might affect the relative price of goods in one location.Consequently this falls short of the law of one price andarbitrariness creating an imperfect competition(Lamont & Thaler 200).The pricing of commodities based on home costs limits an alternativeto price differentiation(Taylor& Taylor 142).
Thelack of conformity in PPP is much evident in single commodities thanit is with aggregate price indices(Lamont& Thaler 197).In particular, this deviation is common in situations of moneydisturbances. However, during inflations, the cumulative prices ofgoods show close a relation to PPP although there are disparities inrelative prices. In times of high inflations, there are changes inwages, exchange rates and prices which have an overall effect on therelative prices(Rogoff35).A good example of this case is the 1970 economic shock resulting fromoil embargos, shortages, supply shocks and shift in demand for moneyas a means of exchange rate this brought a systemic disparity in thepurchasing power parity theorem compared to the 1920s(Cassel87).
Ithas also been hypothesized that, divergent in prices lead toexchanges depreciation (Taylor& Taylor 139).Therefore,as espoused in the structural disparities of PPP, this evidencesupports the facts that real exchanges do not show constancy.Differential in productivity in different locations and the relativeincomes systematically alters the relative prices of the non-tradableand tradable goods in any given country(Krugman87).The persistent and large deviations in PPP could also be attributedto capital flows from international monetary fiscals that interactwith other changes in prices and wages to bring about disparities inthe PPP(Lamont & Thaler 191).
SuitabilityofObjectsused forPPP comparisons
GrowthDomestic Product (GDP)
Asindicated from the above arguments, the objects of comparison usedfor PPP has never been accurate as a true measure of PPP exchangerate. In particular, GDP cannot be categorically used as a truemeasure of PPP mainly becausethere is always government intervention in the financial marketsthrough hedging policies, interest rates have for long affected thecurrency exchange rate. In addition, during inflation governmentintervenes in making adjustments on wages, commodity prices andexchange rates. The overall effect is that individual incomes andrelative prices of commodity vary from country to country even ifthey are identical. As such, GDP cannot be effectively used as acomparison of PPP between two countries even when the income currencyis one(Tim 2).
Similarly,GDP is inclusive of both productive and unproductive work as well asblack market activities(Tim2).In addition, GDP does not include depreciation of machineries andother assets that are used in its calculation. GDP is also calculatedfrom different sources and current prices which mean it needs to beadjusted for inflation before making comparisons with othercountries(Taylor& Taylor 150).Another important aspect is that, in most developing economies andemerging markets there are more cheaply non-traded goods thandeveloped countries this affects the GDP, meaning that there existsgreat deviation in PPP when comparing two countries GDP. Overall, GDPdoes not capture all aspects in any given country and, therefore,cannot be used to make standard exchange rate comparisons(Krugman 88).
TheBig MAC burgernomics/ The Law of one-Price and the PPP
Althoughthe attractive feature of The Big Mac serves as a standard ofmeasuring the PPP in any given country based on the fact thatingredients used are same(Lamont & Thaler 195).However, this theorem does not effectively meet the tenets of PPPbecause there exists salient difference in the production of theseproducts in different countries production costs vary depending onthe cost of labor. As the pricing of the Big Mac indicates indifferent countries, there exists a great disparity in the PPP(Pakko & Pollard 8).
Thisdisparity could be attributed to such factors as trade barriers thatinclude transportation costs, trade restrictions and taxes. In arejoinder, the disparity in prices is solely attributed to otherfactors such as non-traded goods that affect the production cost ofthe product from one place to another (Rogoff 24). Therefore, thismeans that there cannot be an absolute PPP this is only possible ifcommodities are easily transferableand no cost to impose a disparity. This is not possible in an idealworld(Cassel 156).
Doesthe theory of Purchasing Power Parity Hold?
Althoughthe PPP perspective is an important benchmark in assessing long-termequilibrium of currency exchanges, its predictive capacity isrelatively low. The idea of PPP is a good based on the law of oneprice that advocates for identical prices of identical tradable goodsacross borders based on the same currency. However, there existdisparities from this reasoning. There is salient trade transactionpractices interference that affects the stability of relative pricesof commodity used to make PPP estimates.This disparity is attributed to such factors as trade barriers thatinclude transportation costs, trade restrictions and taxes.
Similarly,the disparity in relative prices is contributed by other factors suchas non-traded goods that affect the production cost of the product(for instance The Big Mac). This means that there cannot be anabsolute PPP this is only possible if commodities are easilytransferable and no cost to impose a disparity. The effect is that,the law of one price is violated by these forces. In addition, thereexists considerable product differentiation prices are dictated bythe manufacturers and not the market forces, and those relativeprices of goods are affected by no-tradable goods. However, thetheory of PPP holds due to international arbitrage under the tenetsof absolute PPP and relative PPP adjustments.
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