"Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate."
The purpose of this paper is to consider one of the most controversial theory in international economics – Purchasing Power Parity theory – its main idea, empirical evidence, limitations and practical application. The main idea of PPP is price levels changes determine the exchange rate change between two countries. There are two versions of PPP theory absolute and relative. Stricter absolute version of PPP did not find confirmation in reality and relative version of PPP theory was proposed. Despite theoretical and practical inconformity, PPP is present in many models of international economics as an explanation of exchange rate changes.
The main apologist of PPP theory and its father was Gustav Cassel. He indicated that the exchange rate determined by price levels is not necessarily the actual exchange rate but the equilibrium one. Also Cassel mentioned that there is a tendency for the actual exchange rate to return to its equilibrium exchange rate. The original idea of PPP theory is described below:
“Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses a purchasing power as against commodities and services in that foreign country.” In this paper we considered the principle and two versions of PPP theory, discussed its empirical evidence and econometrical tests, and also tried to find possible reasons why PPP theory fails in reality and answered the question is this theory still useful for explaining exchange rates movements.
Table of Contents
Introduction
I. Purchasing Power Parity theory
1. The Law of One Price and the Purchasing Power Parity
2. Absolute PPP and relative PPP
3. PPP and the mechanism of exchange rate determination
II. Looking for empirical evidence of PPP theory
1. Informal test of PPP theory
2. Formal tests of PPP theory
III. The Critics and Usage of PPP Theory
1. Limitations and Critics of PPP Theory
2. The Usage of PPP Theory
Conclusions
Objectives and Research Themes
The primary objective of this paper is to examine the Purchasing Power Parity (PPP) theory, specifically its conceptual framework, empirical validity, structural limitations, and practical applications within international economics. The central research question explores why the theory often fails in real-world scenarios and assesses its continued relevance for explaining fluctuations in exchange rates.
- The core principles of absolute and relative Purchasing Power Parity.
- Empirical methods for testing PPP, including informal graphical analysis and formal econometric models.
- Theoretical limitations, such as trade barriers, transport costs, and market imperfections.
- The role of the Balassa-Samuelson effect in creating biases within PPP.
- Practical utility of PPP for international companies and institutions in comparing economic indicators and assessing foreign exchange risk.
Excerpt from the Book
1. The Law of One Price and the Purchasing Power Parity
In general the PPP describes the price relatives, which is expressed by the ratio of a national currency of the identical good or service in different countries. A popular example about the PPP is the “The Big Mac Index” published by The Economist Magazine. The Big Mac PPP shows the exchange rate that would mean that Big Mac’s cost abroad as much as in the United States (Appendix 1).
The LoOP is the foundation of the PPP theory. It assumes that goods in two different countries are sold for the same prices without taking into account an existence of transportation costs, tariffs, taxes and other barriers to trade. The LoOP states that the price of an identical good, which is traded on competitive markets, will have the same price in every trade-related country, when the price is indicated in the same currency. This statement shall be explained in the following example by means of the “iPod” price, Pi, which is sold in two competitive markets without any significant trade barriers or transaction costs, like transportation costs or tariffs, for example in the United Kingdom (UK) as domestic market and in United States (US) as foreign market.
Summary of Chapters
Introduction: This chapter outlines the controversy surrounding PPP theory, establishes the paper's scope, and introduces the key objective of investigating why the theory frequently deviates from empirical reality.
I. Purchasing Power Parity theory: Explains the conceptual relationship between exchange rates and price levels, detailing the Law of One Price as well as the distinction between absolute and relative versions of the theory.
II. Looking for empirical evidence of PPP theory: Provides both informal graphical comparisons of price indices and formal econometric tests to evaluate the short-run and long-run validity of PPP.
III. The Critics and Usage of PPP Theory: Analyzes the theoretical drawbacks and real-world limitations that cause PPP to fail, while also highlighting its practical significance for international comparisons and corporate finance.
Keywords
Purchasing Power Parity, Law of One Price, Exchange Rate, Absolute PPP, Relative PPP, Empirical Evidence, Econometrics, Unit Root Process, Cointegration, Arbitrage, Balassa-Samuelson Effect, Price Levels, Inflation, Foreign Currency Exchange Market, International Economics.
Frequently Asked Questions
What is the core subject of this research paper?
The paper fundamentally deals with the Purchasing Power Parity (PPP) theory, investigating its theoretical principles, its predictive power regarding exchange rates, and why it is considered one of the most controversial theories in international economics.
What are the central themes discussed in the work?
The central themes include the mechanism behind exchange rate determination, empirical testing of PPP through various statistical methods, the systematic limitations of the theory (such as transport costs and trade barriers), and the real-world applications for multinational corporations and international institutions.
What is the primary objective of the study?
The objective is to analyze the principle and versions of PPP, discuss empirical and econometric evidence for its validity, identify reasons for its failure in real-world scenarios, and answer whether the theory remains useful for explaining exchange rate movements.
Which scientific methods are employed?
The paper employs a mix of descriptive economic analysis, graphical illustration (e.g., comparing inflation and exchange rate trends), and a review of formal econometric approaches including univariate, bivariate, and trivariate testing, unit root tests, and cointegration analysis.
What is covered in the main body of the paper?
The main body systematically progresses from the basic definitions of PPP and the Law of One Price to empirical testing across different time horizons, finishing with a critical look at the assumptions of the theory and its practical utility in macro- and micro-level applications.
Which keywords characterize this work?
Key terms include Purchasing Power Parity, Law of One Price, Exchange Rate, Arbitrage, Empirical Evidence, Econometrics, and Balassa-Samuelson Effect.
How does the Balassa-Samuelson effect impact PPP theory?
The Balassa-Samuelson effect is presented as a factor that makes PPP a biased theory. It suggests that productivity growth in the tradable sectors of rich countries leads to higher wages and consequently higher prices for nontradable goods, creating an appearance that the currency is "overvalued" despite no actual loss in competitiveness.
Why does the author differentiate between current and constant PPP?
The differentiation is critical for productivity comparisons over time. While current PPP provides a snapshot of productivity levels for a specific year, it cannot be used for growth rate comparisons due to shifting price weights. Constant PPP uses a base year to allow for valid analysis of productivity growth rates across countries.
- Citar trabajo
- Alina Ignatiuk (Autor), 2008, The Principle, Practise and Problems of Purchasing Power Parity Theory, Múnich, GRIN Verlag, https://www.grin.com/document/124460
