Purchasing power parity theory

INTERNATIONAL FINANCE - INTERNATIONAL FINANCIAL MANAGEMENT

1. PURCHASING POWER PARITY THEORY Dr. Mohamed Kutty Kakkakunnan Associate Professor P G Dept. of Commerce N A M College Kallikkandy Kannur – Kerala - India

2. Purchasing Power Parity Theory Currencies are used for purchasing goods and services Value of a currency (money) depends upon the quantity of goods and services that can be purchased by the currency Thus, value of money is its purchasing power Exchange rate can also be mentioned on the basis of this purchasing power Exchange rate is the expression of one currency in terms of another currency Eg INR 60 = $ 1

3. Suppose by using Rs 60, we can purchase one kilogram of orange, then the purchasing power of Rupees can be expressed as – Rs 60 = 1 kg orange Similarly for purchasing one kg orange, we have to pay one dollar, then the purchasing power of dollar can be expressed as – $1 = 1 kg orange Now it is possible to state the exchange rates in terms of the value of orange Rs 60 = 1kg orange = $ 1 Now it is possible to express the exchange rate in terms of their purchasing power as INR 60 = $1 This expression is on the basis of the parity of purchasing power of the two currencies

4. Purchasing power of currency changes due to inflation or deflation When there is inflation, price level increases, quantity of goods that can be purchased by one unit of currency declines, thus, the purchasing power also decline and vice versa Thus, inflation / deflation affect the exchange rates Purchasing power parity theory explains the relationship between exchange rate and inflation This theory is based one “Law of one price”

5. Law of one price states that any commodity cannot command two different prices in two different markets. If so profits can be taken by trading between these two markets. Ultimately the difference will set off the price differential and prices of the two markets become equal. PPP theory was proposed by David Ricardo, 19 th century, popularized by Gustav Cassel –in 1920s According to this theory, exchange rate of a commodity is determined on the basis of the purchasing power of the currency

6. This theory considers foreign exchange as a commodity Under gold standard, the exchange rate can be stated in terms of the price of “Mint parity of gold” But in flexible or floating exchange rate system – in the era of paper currencies, currencies are not backed up by gold or gold exchange standard, currencies are not based on their intrinsic worth in terms of gold Thus, to determine the exchange rate, purchasing power of the two currencies can be considered In other words, the exchange rate of two currencies can be determined on the basis of products of commodities that can be purchased by the currencies According to this theory exchange rates are determined by what each unit of a currency can buy in terms of real goods and services in its own country

7. The rate of exchange is the amount of currency which would buy the equivalent basket of goods and services in both the countries As mentioned, to purchase one Kg of orange, in India, we have to pay Rs. 50 and at the same time to purchase the same quantity of orange in US, one has to pay $1. in that case Exchange rate (E) = Price of orange in India / Price of orange in US = 50/1 or 50:1

8. Assumptions of law of one price and PPP theory There exist perfect market conditions Absence of transportation costs from one market to another (country to another) Free trade across the international market No barriers or controls over international trade like tariffs, taxes, incentives, promotions etc No country is strong enough to influence the exchange rate The above mentioned practices are termed as frictions in trade and are distortions in free markets If the above assumptions hold good, law of one price will prevail

9. There are two versions to the PPP theory The absolute PPP (Positive version) and The relative PPP (Comparative version) Absolute PPP Theory In the olden days (1700 -1970) gold formed the basis for determination of the exchange rate because it commanded good demand all over the world Today, gold is like any other commodity Thus, in the olden days PPP was based on gold prices According to the Jamaica Agreement in 1976 gold was demonetized The PPP and the exchange rates are not determined or governed by a single commodity like gold Now, it comprises of a basket of commodities in which gold is only a commodity

10. Thus, for the purpose of determining the exchange rate a basket of commodities which have common utility among the natives will be considered. The value of commodities in different places may differ according to customs, traditions, culture, believes etc. For determining the inflation rates, every country forms a common basket of goods in proportion to their utility to the people Based on variations in prices inflationary tendencies are determined.

11. Inflation influences exchange rates Two countries India and China. Inflation rate in India is 20% and that of China is 0%; then the INR will depreciate when compared to Chinese Yuan. In other words, Chinese Yuan will appreciate when compared to INR Formerly the currencies were in equilibrium position and were traded INR 5 = 2 Yuan on account of inflation the position can be INR 6 = 2 Yuan Now Chinese get more INR for their Yuan and they can purchase more goods from India by giving their Yuan This will increase Chinese import from India and or Indian export to China.

12. Thereby increasing demand for Indian Rupees from Chinese who pay in term of their Yuan. Demand for INR leads to increase exchange rate of INR and increased supply of Yuan tends to reduce the price of Yuan. Thus, ultimately through the interaction of market forces, the exchange rate reaches again in equilibrium position

13. Demerits Assumes composition of common basket of goods. Due to factors like culture, tradition, values believes etc. common goods may not be the same Assumes identical utility – but utility is different Quality of goods may be different in different countries Styling and packing difference Trade barriers Transportation, insurance cost etc Non-tradable goods (service, human resource) Time lag : consequence of inflation may occur in different time Other factors affecting demand and supply of currencies - interest, investment portfolio returns etc

14. Relative Purchasing Power Parity Theory Absolute PPP theory has certain limitations or distortions – thus, may not hold good Thus, Relative PPP theory This theory considers the impact of market imperfections like transportation cost, tariffs, quotas, incentives etc. Imperfections result in different prices for the same commodities in different countries, even if measured in a common currency However, this theory argues that “the rate of exchange in the prices of products will be some what similar when measured in common currency, as long as the transportation costs and trade barriers are unchanged In other words, “the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in two countries over the same period”

15. Example, Suppose:- t = 0 (base period or year) Pₒd = Price of the commodity in domestic country during the base period Pₒf = Price of the commodity in foreign country during the base period Thus, exchange (spot) rate = Sₒ = Pₒd / Pₒf Suppose if the prices changes due to inflation, after one year the situation will be t = 1 (after one year) P₁d = Price of the commodity in domestic country after one year P₁f = Price of the commodity in foreign country after one year Thus, exchange (spot) rate = S₁ = P₁d / P₁f

16. P₁d = Pₒd + inflation in domestic country P₁f = Pₒf + inflation in foreign country If, Inflation in domestic country = Id inflation in foreign country = If Thus, S₁ = Pₒd ( 1 + Id) / Pₒf (1 +If) or

17. Suppose the price of 1 kg orange in India is INR 50 and that in USA is $1. The inflation rate in India is 20% and that of USA is 10%. Determine the new exchange rate When t=o, Sₒ = Sₒ = Pₒd / Pₒf = 50/1 = INR50: $1 t=1, inflation in India (Id), 20 % 0r 0.2 and inflation in USA (If) is 10% or 0.1 Present exchange rate will be 50 x (1+0.2/1+0.1) = INR 54.45 : $ 1

18. Nominal exchange rates and Real exchange rates Nominal rate is the current rate or prevailing rate without making any adjustment for inflation Real rate is the nominal rate adjusted to the inflation or price level changes Since due to inflation, the purchasing power of currency declines, thus, in such situations, the currency is said to be depreciating its value