Purchasing Power Parity - its theoretical perspective and empirical evidence

Table of Contents

Introduction

Purchasing power parity
Absolute purchasing power parity
Relative purchasing power parity

Empirical evidence

Conclusion

References

Bibliography

Appendix

Introduction

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.

Purchasing power parity

The PPP theory concerns exchange determination, with the concept that if in two different countries the same product or service is sold but without any sales restriction or occupation of transaction costs, the price should be identical in both countries. This is the law of one price (henceforth LOP), which is not followed could lead to potential arbitrage. However the supply and demand eventually equalise the different prices between the markets (Eitemann et.al., 2004). PPP’s focus is on how the exchange rate is influenced by inflation rate differences between two countries (Demirag and Goddard, 1994). There exist two versions of PPP, the absolute and the relative (Wang, 2005).

Absolute purchasing power parity

The law of one good, one price represents absolute PPP with a formula illustrated by Wang (2005, 34):

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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).

illustration not visible in this excerpt

Source: Economist (2008b)

The table illustrates that only a few currencies are near to the Big Mac PPP. A closer inspection of the precise figures (see appendix), obtained from an article in the Economist (2008a) indicates that the Federal Reserve’s major currency index is overvalued: Euro Area +50%, Canada +14%, United Kingdom +28%, Switzerland +78%, Sweden +79%. The exceptions are Japan -27% and Australia -6% which are both undervalued. Compared to the year 2007 only the Japanese Yen was undervalued by 27% against the dollar. In addition the table illustrates that Asian currencies, particularly the more impoverished countries, such as Malaysia, Thailand and Indonesia, are at the end of the list. Furthermore, Brazil and Turkey, both with high interest rates, protrude from emerging market currencies traded higher than their Big Mac PPPs. However, one would be ill-advised to draw firm conclusions about fast food prices; as they differ with local costs, such as wages and rent This is the same for across borders traded ingredients, value-added taxes or different profit margins, and it is for these reasons that Rogoff (1996, 650) criticize that Big Macs are differently “bundled”.

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