Question

Fortunately, the theories of both purchasing power parity and interest rate parity do not have any problems. Do you agree with this statement? In 300 words, defend your position.

Answer 1

Let us state briefly both the theories in the first place-

Theory of Purchasing Power Parity-Developed by Prof. Gustav Cassel, the theory states that the rate of exchange between two countries depends upon the relative purchasing power of their respective currencies. It is an economic theory that compares different countries currencies through a "basket of goods" approach. This concept implies that two currencies are in equilibrium when a basket of goods is priced the same in both countries taking into consideration the exchange rates.

Theory of Interest Rate Parity - The theory suggests a dual relationship between interest rates and the movement of the currency values. Simply, one can predict what a future exchange rate will be by looking at the differences in interest rates in two different countries. It is used to explain the value and movement of exchange rates and further refers to a condition of equality between the rates of return on comparable assets between the two countries.

When we talk about the consequence of such theories, problems have been traced so it would be a vague statement in order to simply ignore the problems of the above-mentioned theories and say that they are efficient in all cases held.

Firstly we would talk about the Purchasing Power Parity (PPP) Theory: We know from the basic outline of the theory that the PPP calculations are based on comparing the prices of identical goods in different countries and these should be the goods that are most commonly represented in total expenditure. When "basket of goods" are priced the same across borders in different nations, it implies that the goods are at their best very similar goods but in reality, it is impossible to find such identical goods across different countries. Nations vary with respect to the transportation costs and trade restrictions which definitely results in varying prices of such and such goods. Another problem associated with the PPP theory is discovering the actual prices of goods and services and determining the representative prices in each country. This theory states that good can be traded without any restraints and it doesn't take into account any tariffs on imports or taxes but when the index of PPP there are few factors ( such as interest rates, trade flows, and inflation ) that cannot be ignored

In the second place lets not agree that the theory of Interest Rate parity is free from errors: The theory has shown lesser proof of working in recent years. To note here that in many cases, countries with higher interest rates have often experienced appreciation in its currency due to higher demands and higher yields and it has a little or nothing to do with riskless arbitrage. We learn that the theory assumes that there are infinite funds available that can be used for currency arbitrage which does not stand realistic because when futures or forward contracts are not available to hedge, interest rate parity does not tend to hold in the real world. Also, currencies of countries where interest rates are high in almost all cases increase in value and this happens because the central banks are determined to cool an overheating economy by raising the rate of interest and hence this influence on currencies is not related to arbitrage ( which violates the working principle of the theory which basically states that if two countries have two different interest rates, this difference will lead to a discount for the exchange rate in order to avoid arbitrage opportunities).

Conclusion- Both the theories of Purchasing Power Parity and Interest rate parity do have problems in full operation of its implementation and thus holds criticism towards it.