Question

1. Explain the two concepts of absolute and relative purchasing power parity. Do you believe that either absolute and/or relative PPP hold?

2. Why does the carry trade offer such attractive returns?

Answer 1

Purchasing Power Parity or PPP assumes a similar price exists for a basket of goods in multiple countries as per the Law of One Price.

The Law of One Price states that the price of freely-traded goods around the globe will be same considering that the transactions are carried out in the same currency. Theoretically, the price will keep on adjusting in case there is any arbitrage opportunity till an equilibrium is reached. SO it essentially assumes that there is no difference in transaction costs i.e. either transaction costs are zero or same.

In reality, transaction costs depend on the geographical location of the seller and the buyer. So the Law of One Price is true if any external costs, other than the cost of products themselves, are eliminated like transportation costs, tariffs, taxes, and other location-specific costs.

For example, we compare the price of flour in US and UK,

• Let's suppose that the price of wheat in the US is $4 per bushel
• If the GBP/USD currency pair value is 2.000, then, excluding any external costs, the price of one bushel of flour in the UK should be 4/2.0 = £2.00
• If the price is different from this, there is an opportunity for an arbitrage.

If flower was cheaper than £2.00 in the UK, traders could purchase the flour in UK and sell it at a higher price in US for profit. These trades would push up the price of wheat higher in UK and lower in the US. This would continue until an equilibrium was reached, and same prices existed in both countries if compared in a similar currency.

Absolute PPP states that exchange rates are in equilibrium if the value of a basket of goods and services are the same between two countries. As per Absolute PPP, market forces will change the exchange rate and adjust it if the prices are not equal.

Comparing country 1 to country 2, with exchange rate E, as per absolute PPP,

The Price of a basket in country 1 = The Price of a basket in country 2 x E

or E = The Price of a basket in country 1 / The Price of a basket in country 2

So, absolute PPP exchange rate is the the ratio of the value of a basket of goods in one country, with another country. Underlying assumptions are the baskets are equal and all goods and services ahve the same weightage.

To overcome the issue of identical baskets, the conceot of Relative PPP was introduced.

The relative PPP, states that the change in the exchange rate of 2 countries reflect the changes in the ratio of the price levels

The absolute PPP indicates that the exchange rate has to reflect the ratio of two countries’ price levels with no other external costs. However, in reality, there are market imperfections and externalities. So relative PPP takes into account these market imperfections and relaxes the relationship between the exchange rate and the price levels of two countries. This is achieved by considering the change in exchange rate and change in ratio of price.

The fact that absolute PPP cannot hold has been well established and that is the reason why Relative PPP has been brought into picture. However, there are drawbacks of relative PPP as well. This is because there are barriers to trade. We do not trade in a perfect world with no transportation or other associated costs. Price information is not readily and perfectly available with everyone. So, arbitrage might not adjust all price discrepancies. Taxes and tariffs are real-world barriers which hinder international goods movement.

There is also the effect of non-traded costs like labour and land. PPP also works on the assumption that markets are perfectly competitive which is never possible in a real world. However, the same good may be elastic in one place and inelastic in another. So there will be an interference. Thus neither absolute not relative PPP can completely hold true.

If you found this helpful, please rate it so that I can have higher earnings at no extra cost to you. This will motivate me to write more.