Purchasing power parity theory free essay sample

Purchasing power parity theory is used to examine and contrast different Currency. Purchasing power parity (PPP) is the economic concept and the method used for determining the comparative value of currencies, evaluating the sum of adjustment required on the exchange rate between states sequentially for the exchange being equal to (or on par with) purchasing power of every currency (Balassa, 2004). This theory asks how much capital would be required for purchasing the similar goods and services in 2 states, and utilizes that to estimate the implicit foreign exchange rate (Redding, 2000). By means of that purchasing power parity rate, the amount of capital therefore has the similar purchasing power in different states. Amongst other uses, PPP rates make possible global evaluation and contrast of profits, as marketplace exchange rates are frequently unstable, are influenced by political as well as financial factors which don’t cause direct changes in income and are liable to methodically minimize the standard of living in under-developed states (Patel, 2000). We will write a custom essay sample on Purchasing power parity theory or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Discussion The theory of purchasing power parity may be divided into 2 types namely: ? First is the theory of absolute purchasing power parity ? Whereas the other one is relative purchasing power parity theory The formula of the absolute purchasing power parity theory is S = P / P*, Where S is the exchange rate, P and P* stand for the level of regional and foreign price of the same collection of products in that order (Mark, 1995). The absolute PPP indicates that when the level of domestic price raises comparatively, the domestic currency’s purchasing power falls down consequently (Alan, 2004). That is, the currency diminishes and the exchange rate declines, and on the contrary. Whereas the formula of the relative purchasing power parity theory may be based on the formula mention below: %? S = %? P %? P*, Where %? S is the rate of variation in the exchange rate, %? P and %? P* are the domestic and foreign inflation rate correspondingly (Redding, 2000). Relative PPP states that the exchange rate’s change rate equals the difference between the domestic and foreign inflation rate. If compare Relative PPP with the absolute purchasing power parity, the relative PPP is more valuable, and its information is easy to get (Abuaf, 2006). In a nutshell, the PPP theory is the most important exchange rate determination theory, and it is derived from the quantity theory of money, interpret the exchange rate behavior from the quantitative standpoint. Furthermore, the theory begins to analyze the problem from the fundamental function of money (purchasing power), and is simple to recognize. The formula is easy also (Yoonbai, 2009). However, the purchasing power parity theory is not a comprehensive idea of exchange rate determination. This theory doesn’t shape the cause-effect relations between the price and the exchange rate in a clear way (Abuaf, 2006). The thought that the same items in different states must have the similar actual prices is extremely instinctively attractive- in spite of everything, it stands to reason that the consumers must be capable to put up for sale any item in single state, exchange the money got for the item for currency of another state, and after that purchase the similar item back in the other state (and not have money available at all), if for without any reason than this situation only puts the customer back accurately where it began (Alba, 2010). This idea, called purchasing-power parity (and occasionally referred to as purchasing power parity), is just the concept that the amount of purchasing power which consumers have does not rely on what currency it is making purchases with. Purchasing power parity; not a practical concept Instead of its instinctive attraction, purchasing power parity does not usually hold practically. This is because PPP depends on the existence of arbitration opportunities- opportunities to risklessly and costlessly buy items at a lower price in single place and puts up for sale them at a high rice in another- for bringing prices together in different states (Abuaf, 2006). (Prices would converge as the purchasing activities would push prices in single state up and the selling activities would push prices in another state down. ) In reality, there are different transaction costs as well as obstacles to buy and sell that restrict the capability to make prices converge through marketplace forces (Redding, 2000). For instance, it is not clear how one would take advantage of arbitrage opportunity for services across diverse geographies, as it is frequently hard, if possible, to convey services without cost from place to place (Balassa, 2004). But, PPP is a vital idea to think as the baseline theoretic state, and, although PPP may not hold in a perfect way in practice, the instinct behind it does, in reality, place practical limitations on how many real prices may deviate across states (Patel, 2000). PPP theory is the concept that exchange rates between various currencies will of course choose a position which denotes the similar goods cost the similar price in all states. Purchasing power parity theory states that where this is not the case, the reason is transaction costs and hurdles to trade. In reality, PPP theory is definitely not verified, although supporters of this theory would state that this only demonstrates the level of obstacles to a free marketplace (Alba, 2010). The reason behind the PPP theory is based on the idea of the law of one price. During the absence of local tax changes or transport costs, the similar good must cost the similar amount in different states (Yoonbai, 2009). The reason behind this is that, in free marketplace theory, people exploit price discrepancies. PPP theory basically takes the law of one price to a collective level. Or we can say that, it observes the collective impacts of the way the law influences every individual item. For instance, the USA traders will require exchanging USA Dollars for pesos so as to purchase the DVDs (Alan, 2004). Across each and every goods as well as services, the theory is that this will have an impact on the exchange rate. The mixture of the goods’ demand and supply in different states, and the demand and supply for currencies, must ultimately cause the purchasing power parity (Alba, 2010). Purchasing power parity theory gives details about variations in the nominal exchange rate which make sure constancy in the actual exchange rate. If PPP theory held, subsequently the real exchange rate would always equivalent. The exports of a state would always purchase accurately the imilar basket of goods trade in from out of the country. But, in reality, real exchange rates show both short run as well as long run divergences from this value. There are lots of critically assessments of the Purchasing power parity theory (Mark, 1995). A number of goods may not be bought and sold simply across borders, making arbitrage complicated or not possible. Other goods are not without discrepancy very sim ilar in every state, making them unsatisfactory alternates and enforcing another barrier to arbitrage (Balassa, 2004). As well, trade obstacles interrupt the competent processes of arbitrage set in the theory. As a result, a different theory is required for explaining trade and exchange rates wholly. In accordance with the Purchasing power parity theory, for calculating the new equilibrium rate one should identify the base rate that is, the older equilibrium rate (Balassa, 2004). However it is not easy to determine the specific rate that really overcome between the currencies like the equilibrium rate. Furthermore, the estimated new rate would show the equilibrium rate at PPP merely if economic state has remained unaffected (Redding, 2000). The Purchasing power parity gets failed to clarify the demand for and the supply of foreign exchange. The Purchasing power parity theory has proved being not satisfactory because of this inattention. As in real practice the exchange rate is settles on in accordance with the marketplace forces like the demand for as well as supply of foreign currency (Abuaf, 2006). It is however a different true criticism that the Purchasing power parity theory is based on the impractical suppositions like absence of transportation cost. In addition, it imperfectly supposes that there is an absence of any obstacles to the global trade. PPP theory can help as the basic estimate but does provide unsatisfactory details of the exchange rate determination (Balassa, 2004). PPP theory as such also experiences critical statistical complexities the complexities related to the calculation of price index. Mainly, the choice of weights (Qo) will very much affect the value of R, if the ratio is not constant. The weights’ different sets will be bound for producing differences in the results (Patel, 2000). To conclude, the real application of the PPP principle for estimating the exchange rate has provided evidence that it can not provide an accurate calculation of the equilibrium exchange rates. Therefore, PPP doctrine can not be helpful to calculate with accuracy the real equilibrium exchange rates. PPP theory is not anything more than a term of a longer period inclination that presumes free functioning of economic forces (Mark, 1995). Purchasing power parity theory can not be used to calculate equilibrium rates or to measure with accuracy divergences from global payment equilibrium (Alan, 2004). At best, PPP theory may be utilized to find the estimated rate by which the equilibrium rate of exchange may be positioned. In practice, PPP is very rare (Alba, 2010). In reality, there are frequently huge price divergences between different areas of the similar state, allow alone between states with 2 different exchange rates (Balassa, 2004). This theory argues that this is due to the divergences in sales taxes between the different states, by the cost of transferring goods between states, and by trade obstacles like import limits or duties (Patel, 2000). Conclusion Purchasing power parity theory suggests a direct functional relationship between the currencies’ purchasing powers of 2 states as well as their exchange rate (Abuaf, 2006). But, in practice there is direct and exact link like this between the two. Several aspects are there despite the purchasing power of currencies, like tax, speculation, capital flows, and so on that considerably influence the exchange rate. It gets failed for taking into account any items in the balance of payments but merchandise trade (Yoonbai, 2009). We can say that the PPP theory is relevant at best just to present account transactions, ignoring capital account totally. Regardless of all the limits, the purchasing power parity theory is the single rational justification of durable changes in exchange rates under all economic situations, gold standard, and so on. Purchasing power parity also gives details about what settles on the balance of payments itself (Mark, 1995). It demonstrates that trades as well as payment between states vary mostly because of changes in comparative levels of price of the states concerned. In the long-run, thus, the exchange rates rely on comparative prices as well as price variations (Abuaf, 2006). This doctrine has its significance when price movements are the important aspect influencing exchange rates. However when price variation is not much significant, this theory is less significant (Alan, 2004). In fact, even though, this PPP has its limitations and weaknesses regarding practical application, it clarifies the functioning of the continuing tendencies in exchange rates that has a vital bearing on ractical strategy in regard to overseas trade as well as payments (Abuaf, 2006). Purchasing power parity theory relates to a static world. Changes in fiscal relationships between 2 states are avoided by this doctrine (Yoonbai, 2009). It gets failed for taking into consideration that the equilibrium exchange rate may also vary following the variation in economic relationships between 2 states, even though, price levels might remain unchanged (Alba, 2010). This theory pre sumes free trade and absence of exchange control for the stable exchange rate based on Purchasing power parity (Mark, 1995). In practice, though, country interference in the free flow of global trade like export taxation, import taxation, import quotas or import licensing and exchange control plans cause an enduring divergence from the rate of exchange settled on by comparative price levels, i. e. the PPP (Alan, 2004). Short-term variations from the PPP can also take place because of the operations of entrepreneurs or because of flow of capital caused by panic.