Question

Please be detailed with your explanation

practice #4

Explain the concept of purchasing-power parity (PPP):

Answer 1

Fundamental questions that managers of MNEs, international investors, importers/ exporters and/or government officials must deal with every day are:

– What are exchange rates determinants?

– Do changes in exchange rates predictable?

The economic theories that link the exchange rates, interest rates and price levels together are called international parity conditions. The core of the financial theory is formed by these international parity conditions, that is unique to international finance.

If the identical product or service can be:

– sold in two different markets; and no existence of restrictions on the sale; and

– if the transportation costs are equal of moving the product between markets, then the price of products should be same in both the markets. This is called the law of one price.

If frictions (transportation costs) do not exist, then the primary principle of competitive markets is that prices will equalize across the markets. Then comparing the prices would require only a conversion from one currency to the other:

                                    P^$ x S = P^¥

Where,

the product price in US dollars is (P^$), the spot exchange rate is (S) and the price in Yen is (P^¥).

The purchasing power parity (PPP) exchange rate could be found from any individual set of prices, if the law of one price were true for all goods and services. If markets were efficient while comparing the prices of identical products that are denominated in different currencies, one can determine the “real” or PPP exchange rate that should exist. This is known as an absolute version of the PPP theory.

Empirical testing of the law of one price and PPP has not proved PPP to be accurate in predicting the future exchange rates. So, generally two conclusions can be made from these tests:

– PPP holds up well over the very long run but poorly for shorter time periods; and,

– the theory holds better for countries that have relatively high inflation rates and underdeveloped capital markets.

{Note: Please read: Rogoff, K (1996) The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34(2), pp. 647-668.}