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The PURCHASING POWER PARITY theory was introduced in the Seventeenth century, whereas the economist most credited with the growth of the theory of P.P.P is Karl Gustav Cassel (1921). His work then on exchanges rates was the central idea behind this theory. The basic concept of the L.O.P forms the foundation of the P.P.P hypothesis, and states that after converting into common currency, identical goods of various companies should trade at one price:
where is the local currency price of a good, (actual nominal exchange rate) is the local currency price of the foreign currency and is the foreign currency price of a good.
The key process that is responsible for the convergence of prices is arbitrage. Arbitrage is the process of buying or selling a good in order to exploit a price differential so as to make a risk-less profit. Once the process starts, it continues until prices have converged to the extent that no more profit can be made.
The law of one price theory can applied to both an intra-country and an international setting; all that is required is conversion to a common currency. The theory does somewhat abstract from reality, since in practice crossing a border does affect pricing. Currently, there are still numerous aspects of international trade that have an impact on country specific prices. Transport costs, tariffs and other non-tariff barriers influence prices and last two distort the prices that are be paid for goods. We need to account for these distortions when working with international prices. The main principle however does not change and price equalization should occur through arbitrage and a greater degree of free trade.
The basic concept of PURCHASING POWER PARITY is the "law of one price". When two goods are expressed in one currency, then two goods will have same price, when expressed in same currency in the absence of various costs Eg: transportation costs, taxes, transaction costs etc. Example, a particular Generator set that is selling for 2250 Canadian Dollars [CAD] in Ontario would cost 1500 US Dollars [USD] in Philippines when the currency rate of exchange between Canada and US is 1.55 CAD/USD. If the price of the Generator Set in Ontario was only 2100 CAD, consumers in Philippines will prefer buying the Generator set in Ontario. If the process (called "arbitrage") is being carried out on a huge scale, the US consumers who are buying Canadian goods would bid for the value of the Canadian Dollar, hence making Canadian goods comparatively more costly to them. The process continues till the goods have the same price. There are three bases with this law of one price. (1)Transporting costs, Barriers in trade, and various other transactions costs, can also be significant. (2) Competitive markets for both the countries. (3) The law of one price only applies to trading goods; fixed goods such as houses, and various services that cannot be transferred.
An economist uses following versions of Purchasing Power Parity:
It basically refers to the equity of price levels among countries. Put directly, the exchange rate between United States and the Canada EUSD/CAD equals to the price level in United States PUSA divided by the price level in the Canada PCAD. Assuming the level of price ratio PUSD/PCAD implies an exchange rate of 1.3 USD per 1 CAD. If today's exchange rate EUSD/CAD is 1.5 USD per 1 CAD, PURCHASING POWER PARITY theory implies that the USD will appreciate (get stronger) against the CAD, and the CAD will in turn depreciate (get weaker) against the USD.
Relative PPP basically relates to inflation rates, i.e. the rates of change. The explanation states that the rate of appreciation in a currency equates to the difference in inflation rates between the home and the foreign country. For example, if United States has an inflation rate of 1% and the Canada has an inflation rate of 3%, the Canadian Dollar will depreciate against the United States Dollar by 2% per year. This proposition will hold well empirically specially when the differences in inflation are large. The application of the Law of One Price depends on the following conditions. They are:
Competition should be there in both countries relating to the goods and services.
The goods which are traded between the countries are covered under this law.
Transportation costs and transactional costs to be considered in the trading of all goods.
The easiest way to calculate purchasing power parity between two countries is by comparing the price of a "standard" good which is identical across the countries. Every year The Economist magazine publishes a light-hearted version of PPP: it's "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries.
'In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage insures that each good is uniformly priced (in common currency units) throughout the world - the "law of one price" prevails'. In reality the law of one price is fragrantly and systematically violated by empirical data due to following explanation:-
In our example earlier we discussed how mispricing in the marketplace for DVDs in the United States and China can lead to arbitrage opportunities. As a result of trade due to these opportunities, the price of DVDs and/or the exchange rates between the dollar and Yuan would reach equilibrium such that the mispricing would be eliminated. In our simplistic example, we failed to account for certain costs of trade, such as that for transportation/shipping. What initially amounted to $5 per DVD in China may very well become $6 per item when transportation costs are taken into account. In the case of DVDs, transportation costs, while eroding profit potential, still leaves significant room for arbitrage. However, for many other products which have poor value to volume characteristics, shipping costs can take away the entire arbitrage opportunity. In effect, due to transportation costs, imports become relatively more expensive than they initially appear in the foreign market.
Perhaps even bigger impediments to PPP are trade restrictions that are put in place by
Various governments. Going back to our DVD example, while accounting for
Transportation costs still leave room for arbitrageurs to profit, trade rules and regulation
can completely wipe out such opportunities. Given the minimal cost of making DVDs
And the significantly lower buying power for consumers in China, U.S.
media/entertainment companies may intentionally set prices at a level that still allows
them to profit in developing markets. However, in order to combat the actions of
Arbitrageurs these same companies are likely to have lobbied domestic and foreign
governments to ban the import of such products. While the example above on DVDs is
Fictitious, recent developments in the pharmaceutical industry clearly show the impact of
Trade restrictions. It is widely known that U.S. based pharmaceutical companies sell many
of their products for significantly lower prices in Canada. As a result of this, various
individuals and businesses of the entrepreneurial mindset decided to resell drugs
purchased in Canada to U.S. consumers at lower prices than that offered by U.S. outlets.
Upon realizing the potential negative impact on profits as a result of such arbitrage, drug makers
lobbied both the U.S. and Canadian governments to ban such transactions. The
end result of such lobbying may just be the complete shutdown of the arbitrage
opportunities that may have lead to an equilibrium price for the drugs. While banning
trade is an extreme form of trade restriction, there are many intermediate actions by
Governments, such as tariffs and quotas, which limit the diversion of prices as calculated
by the PPP theory. Just as in the case for transportation costs, trade restrictions have the
Effect of artificially raising the price of imports and thereby making any mispricing less
Cost of Non-Tradable Inputs
Thus far we have focused on pricing differences between finished goods and the arbitrage
Opportunities that result from such discrepancies. It is also crucial to break down the
Prices of such goods into their inputs, such as material, labor, marketing, rent, etc. Food
Products are often cited as good examples for pricing differences between regions.
Consider the costs incurred by a fast food restaurant in Manhattan versus one in
Tallahassee. Our initial assumption might be that a burger prepared in either location
Should be sold in the same price. After all, a burger is a fairly homogeneous product. Of
Course, from first hand experience, we clearly see that prices do vary even within the U.S.
for the same product. The key reason behind this is that non-tradable inputs such as labor,
Marketing and rent make up a sizable portion of the final cost of our burgers in both
Manhattan and Tallahassee. The higher price of burgers in Manhattan essentially reflects
Higher cost of labor, marketing and rent in the area. For many products trading of inputs
would narrow the price gap between the two locations. However, no arbitrage
opportunities exist in our example since the lower cost of labor and rent in Tallahassee
don't allow us to produce our perishable product there and then sell it in Manhattan.
Similarly marketing in Tallahassee, while cheaper, would have no impact on consumers
in a moderately distant region. We can clearly see from this that non-tradable inputs can
have a significant impact on prices even within a country. The effects of such differences
are often exacerbated when considering product prices between two or more countries,
leading the most basic translation of the PPP theory to again come up short.
Similar to tariffs, taxes prevent PPP from being realized. Differences in national and local
tax policies lead to pricing differences in otherwise equivalently priced goods, which in
turn predict PPP exchange rates that are not meaningful. Looking back at our DVD
example, let us assume that DVDs in both the U.S. and China reached a value of $10 per
disc. At this price level, PPP seems to hold. However, this would change dramatically
when we introduce different tax rules into the picture. Suppose the U.S. DVDs are
taxed at 10% of the sales price and that there are no such taxes in China. This results in
the calculated price of the DVDs in the U.S. to increase by $1 to $11 per disc. At this new
tax affected value, PPP fails to hold, even though the underlying value of the goods in
question is equal. Given the impact of effective price of goods in the marketplace, it is easy to see how different tax policies can have unintended consequences for PPP.
Some researchers believe that PPP fails to hold due to differences in productivity among countries. Specifically, the Balassa-Samuelson theory argues that the including of nontraded goods for price indices leads to high income countries to have extravalued currencies relating to their low income peers. This theory is particularly based on the idea that countries with higher productivity generally having a higher per capita income. Although much of the high income / high productivity jobs are in traded goods for any specific country, the competition for labor leads to higher incomes throughout the economy. As a result, higher incomes in the non-traded sector lead to higher prices for even non-traded goods. This, according to theory, eventually leads to relatively higher price levels and overvalued currencies for countries with relatively higher productivity. Studies have shown that while the Balassa-Samuelson theory seems to hold for countries with significant differences in per capita income, it fails to explain PPP's failure for countries with similar income levels.
In summary, the Purchasing Power Parity theory at first seems to be an elegant way by which to predict exchange rate movements. However, as we noticed from historical evidence, PPP winds up being a somewhat poor tool in that regard for short term exchange rates. For reasons such as transportation costs, trade restrictions, cost of nontradable goods, taxes, productivity, etc., the PPP theory comes up short. Even though this may be the case, PPP may still prove to be useful in gaining a basic understanding of foreign exchange markets. In many ways, the theory of PPP should be looked at in similar light to Modigliani and Miller's theory on capital structure and its effect on firm value. Imperfections in the financial world make M&M's theory less useful in much the same way as imperfections in global trade lead to shortfalls in the PPP theory. However, by singling out the impact of imperfections for either theory, we are able to make them most useful for our individual needs. Thus, PPP may well play a crucial role in foreign exchange markets as imperfections and impediments to global trade are either eliminated or better understood.