The Swedish economist Gustav Cassel developed his theory of Purchasing Power Parity (henceforth PPP) more than 80 years. Ago, and today it is still an essential part of the framework for forecasting exchange rates, which includes parity conditions in international finance. International parity conditions imply purchasing power parity, the Fisher effect, the interest rate parity theory and the expectations theory. “They are the set of equilibrium relationships which should hold between product prices, interest rates, and spot and forward exchange rates assuming a freely floating exchange system.” (Demirag and Goddard, 1994, 70) Unfortunately, these theories do not always work out in reality, especially in times of financial crisis. However, they give us a central understanding of how and why multinational business is related in the world. Sometimes, “the mistake is not always in the theory itself, but in the way it is interpreted or applied in practice” (Eitemann et.al., 2004, 133). This essay will take a detailed look at PPP, its theoretical perspective, and the empirical evidence for it.
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Table of Contents
Introduction
Purchasing power parity
Absolute purchasing power parity
Relative purchasing power parity
Empirical evidence
Conclusion
Research Objectives and Themes
This paper examines the Purchasing Power Parity (PPP) theory, investigating its theoretical underpinnings and evaluating its reliability through empirical evidence to determine its utility as a tool for forecasting exchange rate movements.
- The concept of Law of One Price (LOP) and its limitations.
- Distinction between absolute and relative versions of PPP.
- Analysis of the Big Mac Index as a practical application of LOP.
- Evaluation of empirical studies and econometric methods used to test PPP.
- The influence of inflation, productivity, and market friction on exchange rates.
Excerpt from the Book
Absolute purchasing power parity
The law of one good, one price represents absolute PPP with a formula illustrated by Wang (2005, 34):
The equation above shows that the spot exchange rate is the price’s ratio for similar internationally traded goods between the two countries. This means that price change, as a consequence of owing inflation in one country, is compensated though a swap in the exchange rate (Demirag and Goddard, 1994). Thus, absolute PPP is a “sufficient condition” for no arbitrage trade, however it is not a “necessary condition“. With “necessary“ we want to express that if absolute PPP is violated but trading process costs, like e.g. transaction costs, production factor costs or financing cost, are equal or higher than the arbitrage, there would be no or a negative profit so this would be not at all lucrative for businesses. Furthermore, arbitrage opportunities’ would not exist or be logical, if trading countries did not have access to free trade and are geographically far away, which is explains why in such circumstances, the LOP is limited (Wang, 2005, 33).
One of the best illustrations of the LOP is the well known Big Mac Index from the Economist. This index provides one product: a McDonald’s Hamburger, which is served in 120 countries all over the world in the same way. It is based on the principle that the price stands for its purchasing power (Economist, 2007). Referring to the Economist it is a perfect “fair-value yardstick” to analyse the selected currencies if they are under- or overvalued against the American dollar (Economist 2008b).
Summary of Chapters
Introduction: Provides a historical context of the Purchasing Power Parity theory and its role in international finance forecasting.
Purchasing power parity: Defines the core concepts of PPP, including the Law of One Price, and differentiates between absolute and relative versions.
Absolute purchasing power parity: Explains the mathematical formulation of absolute PPP and uses the Big Mac Index as a practical case study for currency valuation.
Relative purchasing power parity: Details the relative version of PPP, which analyzes changes in inflation differentials to explain exchange rate movements.
Empirical evidence: Reviews historical studies and econometric testing methods regarding the validity and long-term viability of the PPP theory.
Conclusion: Summarizes the findings, noting that while PPP is useful for long-term trends, it remains unreliable for short-term forecasting.
Keywords
Purchasing Power Parity, PPP, Law of One Price, LOP, Exchange Rates, Inflation, Arbitrage, Big Mac Index, Empirical Evidence, Econometrics, Currency Valuation, International Finance, Market Equilibrium, Balassa-Samuelson effect.
Frequently Asked Questions
What is the primary focus of this paper?
The paper explores the Purchasing Power Parity (PPP) theory, analyzing how it defines the relationship between inflation, price levels, and exchange rates in international markets.
What are the two main versions of PPP discussed?
The text distinguishes between absolute PPP, which relates exchange rates to the price ratio of goods, and relative PPP, which focuses on inflation differentials over time.
What is the objective of the study?
The goal is to evaluate whether PPP serves as an effective theoretical framework for forecasting currency movements and to assess its real-world validity.
What methodology is used to evaluate the theory?
The paper reviews existing academic literature and empirical research, including regression tests, unit root tests, and the analysis of the Big Mac Index.
What does the main body cover?
It covers theoretical definitions, the distinction between absolute and relative PPP, and a review of empirical tests conducted over the last 150 years.
Which keywords best characterize this work?
Key terms include Purchasing Power Parity, Law of One Price, exchange rate forecasting, inflation, and market efficiency.
How does the Big Mac Index illustrate the Law of One Price?
It uses a standardized product (a McDonald's hamburger) sold globally to compare purchasing power across different currencies, acting as a "fair-value yardstick."
Why is PPP often considered unreliable in the short term?
The paper highlights factors such as nominal price stickiness, transaction costs, and trade barriers that prevent instant price equalization in the short run.
- Quote paper
- Marc Munzer (Author), 2009, Purchasing Power Parity - its theoretical perspective and empirical evidence, Munich, GRIN Verlag, https://www.grin.com/document/133689
