"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 Key Themes
This paper aims to examine the Purchasing Power Parity (PPP) theory, a controversial concept in international economics. It explores the theory's core principles, its empirical evidence (both informal and formal tests), its limitations, and its practical applications in explaining exchange rate fluctuations.
- The Law of One Price and its relationship to PPP
- Absolute versus Relative PPP and their respective empirical support
- Empirical evidence for and against the PPP theory
- Criticisms and limitations of the PPP theory
- Practical applications and usage of PPP theory in economic models
Chapter Summaries
Introduction: This introductory chapter sets the stage by highlighting the central role of PPP theory in international economics despite its controversial nature. It introduces the core idea of PPP – that exchange rate changes are driven by price level differences between countries – and distinguishes between absolute and relative PPP. The chapter also previews the paper's structure, outlining its exploration of PPP's principles, empirical evidence, limitations, and practical use, referencing key figures like Gustav Cassel and their contributions to the theory's development. The introduction effectively lays the groundwork for a comprehensive analysis of the complexities of PPP.
I. Purchasing Power Parity theory: This chapter delves into the theoretical foundations of PPP. It explains the relationship between currency exchange rates and price levels in different countries, emphasizing that the exchange rate between two currencies is directly related to the price level in the foreign country and inversely related to the price level in the home country. Equilibrium is achieved when the price levels of a common basket of goods in two countries, expressed in a common currency, are equal. The chapter introduces the Law of One Price (LOOP) as the fundamental basis for PPP, illustrating how the LOOP, assuming no trade barriers or transportation costs, leads to the PPP condition. Examples like the Big Mac Index are used to illustrate the concept in practice.
II. Looking for empirical evidence of PPP theory: This section investigates the empirical support for PPP theory. It differentiates between informal and formal tests, exploring the various methods used to assess whether the theory holds true in real-world scenarios. Informal tests might involve simple comparisons of price levels across countries for a common good, while formal tests usually employ econometric models and statistical analysis of exchange rate data and price indices over time. The chapter likely discusses the challenges in testing PPP due to factors like transaction costs, trade barriers, and the differing compositions of price indices across countries. It highlights the successes and failures of various approaches, providing a critical assessment of the empirical evidence.
III. The Critics and Usage of PPP Theory: This chapter examines the limitations and criticisms of the PPP theory, acknowledging its theoretical and practical shortcomings. It addresses why PPP frequently fails to hold true in reality, exploring factors such as deviations from the assumptions of the LOOP, the impact of non-traded goods, and the role of market imperfections and government interventions. Despite these criticisms, the chapter highlights the continued relevance of PPP in various economic models and its use in forecasting exchange rates, emphasizing its value as a benchmark or equilibrium exchange rate even if it doesn't perfectly reflect real-world exchange rates. The chapter presents a balanced view of PPP, weighing its strengths and weaknesses.
Keywords
Purchasing Power Parity (PPP), Law of One Price (LOOP), exchange rate determination, absolute PPP, relative PPP, empirical evidence, econometric tests, inflation, price levels, international economics, Big Mac Index.
Purchasing Power Parity (PPP) Theory: Frequently Asked Questions
What is the main topic of this document?
This document provides a comprehensive overview of the Purchasing Power Parity (PPP) theory in international economics. It explores the theory's core principles, empirical evidence (both informal and formal tests), limitations, and practical applications in explaining exchange rate fluctuations.
What are the key themes explored in the document?
The key themes include: the Law of One Price and its relationship to PPP; absolute versus relative PPP and their empirical support; empirical evidence for and against the PPP theory; criticisms and limitations of the PPP theory; and practical applications and usage of PPP theory in economic models.
What is Purchasing Power Parity (PPP)?
PPP is a theory in international economics that suggests exchange rate changes are driven by price level differences between countries. It posits that the exchange rate between two currencies should equal the ratio of the price levels of a basket of goods in the two countries. This means that the same basket of goods should cost the same in different countries when expressed in a common currency.
What is the Law of One Price (LOOP)?
The Law of One Price (LOOP) is a fundamental concept underlying PPP. It states that identical goods should sell for the same price in different markets when expressed in a common currency, assuming no trade barriers or transportation costs. The LOOP serves as the foundation for the PPP condition.
What is the difference between Absolute PPP and Relative PPP?
Absolute PPP suggests that the exchange rate between two currencies should equal the ratio of the price levels of a basket of goods in the two countries. Relative PPP, on the other hand, focuses on the *change* in exchange rates over time and relates it to the difference in inflation rates between the two countries. Relative PPP is often considered more empirically testable than absolute PPP.
What empirical evidence is presented regarding PPP?
The document discusses both informal and formal tests of PPP. Informal tests involve simple comparisons of price levels across countries for common goods (like the Big Mac Index). Formal tests employ econometric models and statistical analysis of exchange rate data and price indices over time. The document acknowledges the challenges in testing PPP due to various factors such as transaction costs, trade barriers, and differing compositions of price indices.
What are the limitations and criticisms of PPP theory?
The document acknowledges that PPP often fails to hold true in reality. Criticisms include deviations from the assumptions of the LOOP, the impact of non-traded goods, and the role of market imperfections and government interventions. Factors like transportation costs, tariffs, and differences in consumption patterns can all contribute to deviations from PPP.
What are the practical applications of PPP theory?
Despite its limitations, PPP remains relevant in various economic models and is used in forecasting exchange rates. Even if it doesn't perfectly reflect real-world exchange rates, it serves as a useful benchmark or equilibrium exchange rate.
What are the key chapters covered in this document?
The document is structured into several chapters: an introduction, a chapter on the Purchasing Power Parity theory itself, a chapter examining empirical evidence for and against the theory, and a chapter discussing the criticisms and usage of PPP theory. The document concludes with a summary.
What are the keywords associated with this document?
Keywords include: Purchasing Power Parity (PPP), Law of One Price (LOOP), exchange rate determination, absolute PPP, relative PPP, empirical evidence, econometric tests, inflation, price levels, international economics, Big Mac Index.
- Quote paper
- Alina Ignatiuk (Author), 2008, The Principle, Practise and Problems of Purchasing Power Parity Theory, Munich, GRIN Verlag, https://www.grin.com/document/124460
