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
Objectives and Key Themes
This essay aims to provide a detailed examination of Purchasing Power Parity (PPP), its theoretical underpinnings, and the empirical evidence supporting it. The essay explores the theory's relevance in international finance and forecasting exchange rates.
- Purchasing Power Parity (PPP) theory and its application in exchange rate forecasting.
- The distinction between absolute and relative PPP.
- Empirical evidence for and against PPP, including analysis of the Big Mac Index.
- The role of arbitrage and transaction costs in influencing PPP.
- Limitations of PPP theory and its practical application.
Chapter Summaries
Introduction: This introductory chapter establishes the context for the essay by discussing Purchasing Power Parity (PPP) as a vital component of the international finance framework for exchange rate prediction. It highlights the interplay of PPP with other parity conditions, such as the Fisher effect and interest rate parity, and acknowledges the inherent limitations and challenges of applying these theories in real-world scenarios, particularly during financial crises. The chapter emphasizes the importance of understanding PPP's theoretical underpinnings and empirical evidence for navigating the complexities of multinational business.
Purchasing power parity: This section introduces the core concept of PPP, explaining how it posits that identical goods or services should command the same price across different countries, absent any market restrictions or transaction costs. This is underpinned by the law of one price (LOP), although this is rarely seen perfectly. The chapter introduces the concept of arbitrage, where discrepancies between prices of identical goods lead to opportunities for profit. The discussion then distinguishes between absolute and relative PPP, setting the stage for a deeper exploration of each in subsequent sections, emphasizing the role of inflation rate differentials in influencing exchange rates.
Absolute purchasing power parity: This chapter delves into the concept of absolute PPP, presenting the mathematical formula that links the home and foreign prices of a good or basket of goods to the exchange rate. It explains how changes in price, often due to inflation in one country, are offset by adjustments in the exchange rate to maintain equilibrium. The chapter discusses the concept of absolute PPP as a sufficient but not necessary condition for arbitrage-free trade, highlighting the role of transaction costs, production costs, and financing costs in influencing price discrepancies. The Big Mac Index from the Economist is presented as a real-world example to illustrate the LOP and to analyze currency valuations against the US dollar.
Keywords
Purchasing Power Parity (PPP), exchange rate determination, absolute PPP, relative PPP, law of one price (LOP), arbitrage, inflation, Big Mac Index, international finance, empirical evidence, transaction costs.
Frequently Asked Questions: A Comprehensive Language Preview
What is the main topic of this essay?
The essay focuses on Purchasing Power Parity (PPP), a crucial concept in international finance used to understand and predict exchange rates. It explores the theory's theoretical underpinnings and examines the empirical evidence supporting or refuting it.
What are the key themes explored in the essay?
Key themes include the application of PPP in exchange rate forecasting, the distinction between absolute and relative PPP, empirical evidence (including the Big Mac Index), the role of arbitrage and transaction costs, and the limitations of PPP theory in practical application.
What is Purchasing Power Parity (PPP)?
PPP is a theory suggesting that identical goods or services should have the same price in different countries, considering exchange rates. This is based on the law of one price (LOP), though imperfections exist in reality. The essay differentiates between absolute and relative PPP.
What is the difference between absolute and relative PPP?
Absolute PPP states that the exchange rate should equal the ratio of prices of a basket of goods in two countries. Relative PPP focuses on the change in exchange rates being equivalent to the difference in inflation rates between two countries.
What role does arbitrage play in PPP?
Arbitrage, the exploitation of price differences for profit, is a key factor influencing PPP. If prices differ for identical goods in different countries, arbitrage opportunities exist, driving price convergence and affecting exchange rates.
What is the significance of the Big Mac Index?
The Big Mac Index, used by The Economist, serves as a real-world example to illustrate the law of one price and to analyze currency valuations against the US dollar, providing a practical application of PPP concepts.
What are the limitations of PPP theory?
The essay acknowledges limitations to the PPP theory, including the influence of transaction costs, differences in production and financing costs, and the reality that the perfect conditions assumed by the theory are rarely observed in practice, especially during financial crises.
What empirical evidence is discussed in the essay?
The essay examines empirical evidence both supporting and contradicting PPP. Specific data or studies aren't detailed in this preview but are indicated as a key component of the full essay.
What is the overall objective of the essay?
The essay aims to provide a comprehensive understanding of PPP, its theoretical basis, and its practical application in international finance, particularly in exchange rate forecasting. It seeks to analyze its strengths and weaknesses.
What are the key words associated with this essay?
Key words include Purchasing Power Parity (PPP), exchange rate determination, absolute PPP, relative PPP, law of one price (LOP), arbitrage, inflation, Big Mac Index, international finance, empirical evidence, and transaction costs.
- Quote paper
- Marc Munzer (Author), 2009, Purchasing Power Parity - its theoretical perspective and empirical evidence, Munich, GRIN Verlag, https://www.grin.com/document/133689
