Essay on Purchasing Power Parity (PPP) | Management Assignments

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Essay on Purchasing Power Parity (PPP)

This essay is an attempt to discuss the various market fundamentals using the theory of Purchasing Power Parity as a measure for tracking exchange rate movements. The later part of this essay aims to compare PPP theory with other exchange rate theories and justify why or why not PPP theory is the best measure to analyze market fundamentals.


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Purchasing Power Parity (PPP) – Business Studies Essay


Exchange rates have much importance in international trade and international comparisons. Foreign exchange is an instrument that enables carrying out a payment from one currency to the other. There have been several theories for exchange rate determination such as the Purchasing Power Parity method, Balance of Payments theory, the Monetary approach to exchange rate determination, etc. These will be discussed in comparison with the PPP method in later parts of this essay.

There are different kinds of exchange rates- free-floating, currency pegs, spot vs forward, etc. Since changes in the exchange rate are critical for international businesses, it is useful to understand the direction in which exchange rates might move in the future. Generally, exchange rates are determined by the interaction of supply and demand unless the government or central bank intervenes and influences exchange rates. The Balance of Payments method gives us useful insight into why exchange rate prediction is difficult.

Dating back to 2000, Americans flocked to Paris for French cuisine and shopping for designer clothing. This sudden rise in demand for French products was because of a change in French prices when measured in terms of dollars. The prices in France in terms of dollars have fallen so much that they covered the cost of the airplane ride to France. Thus comes the concept of the exchange rate- it is the value of one nation’s currency in terms of the currency of the other nation. In a sense, an exchange rate can be viewed as an asset price thus a way of transferring purchasing power from the present to the future. The dollar/euro exchange rate today will depend on what expectations people have of this rate in the future.

It is useful to view the determination of exchange rates via market fundamentals- supply and demand. The demand for a currency consists of exports, foreign direct investment, portfolio investment, and finally the expectations of people regarding the appreciation of the currency. It is interesting to note how these expectations impact the exchange rate. The expectations depend on interest rates, inflation, prospects for the economy, political stability, and desire for a ‘haven’. The supply of a currency comes from imports, domestic residents who want to buy foreign assets, speculators who hope the currency to depreciate, and the money supply from the central bank.

In the short and medium-term foreign exchange markets cannot be relied on to adjust to economic fundamentals. Interest rates were the principal determinant of currency markets in 2007. Thus, the best-performing currencies were those with the highest ‘yield’ and major trade deficits such as New Zealand, Turkey, and the UK, while countries with low interest rates and large surpluses, such as Japan and Switzerland saw their currencies fall against the former countries. Other empirical evidence on exchange rate determinants comes from the Annual Report of the Bank for International Settlements (2006, 79), which stated that: “three main factors underpinned exchange rate developments [in 2005 and 2006] … interest rate differentials … current account and net international liabilities of the United States … [and] continuing reserve accumulation in China …” However, in practice, hedge fund managers and currency ‘players’ pay little attention to economic fundamentals until there is a major geopolitical event.

Thus we see that exchange rates are determined by interest rates and expectations about the future. It is important to note that these factors are influenced by conditions in national money markets. The PPP theory says that in the long run exchange rates move so that purchasing power parity is preserved. Thus this implies that exchange rates should move in line with inflation. If US inflation is above the UK, then the dollar should depreciate against the pound.

The investors are particular about interest rates thus they move money to where rates are high thus causing the value of the currencies in these high interest rate countries to rise, at least in the short run. What we notice is that “in the long run there seems to be a relationship between interest rate differentials and subsequent changes in spot exchange rates.” [but] it is not a good predictor of short-run changes in spot exchange rates.”

Long-term factors such as current account balance imply that purchasing power parity may not be maintained. Countries that have large current account deficits will tend to have weak exchange rates relative to PPP. According to classical theory, exchange rates act as a balancing mechanism to reduce the deficit. There are other factors such as transactions of the central bank, political stability in the country, oil prices (rising oil prices have been associated with a decline in dollar value), etc which impact exchange rates. Thus it is difficult to predict the exact direction of exchange rate movements as there is a multitude of factors that affect exchange rates in the short run and the long run.

We saw above that the Purchasing Power Parity Theory is useful in determining exchange rates. The theory of purchasing power parity states that the exchange rate between two countries’ currencies equals the ratio of the countries’ price levels. The PPP theory predicts that a fall in domestic purchasing power or an increase in the domestic price level leads to a proportional depreciation of the domestic currency in the foreign exchange market. While it is true that PPP between two currencies is determined by the ratio of respective purchasing power, however, this parity is modified by the cost of transportation- freights, insurance, etc. This causes the exchange rates to fluctuate.

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The Big Mac index is based on the theory of PPP: in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. This index developed by The Economist in 1986 serves as a good proxy for ‘a basket of goods’ and helps gauge the direction of exchange rate movements in the long run.

Does PPP theory do a good job of explaining actual data on exchange rates? According to Krugman and Obstfeld (2006, 379), “all versions of the PPP theory do badly in explaining the facts. In particular, changes in national price levels often tell us little about exchange rate movements.” Some criticisms of this theory are- a) assumption of the direct functional relationship between the purchasing power of two currencies. In practice, this might not be true and is influenced by BOP account situation, tariff structures, etc.; b) the price index numbers that are used for the construction of PPP might not be comparable owing to differences in the choice of the base period, the basket of commodities, etc.; c) this theory neglects the BOP and it might not be in equilibrium; d) assumption of free international trade and laissez-faire; e) the economic international relations between countries might change and the theory doesn’t account for that; f) the theory is relevant in the long run only when the changes are purely monetary and no structural changes.

Thus the PPP theory has mixed responses in terms of it being a good theory. However, it is useful in explaining some notable characteristics of exchange rate movements. If the relative inflation rates of two currencies diverged in the beginning from the equilibrium, then the actual rate in the markets is expected to balance that relative change in inflation to leave the underlying real exchange rate unchanged. The problem that we encounter here is that the equilibrium exchange rate depends on the macroeconomic model used thus its prediction at any point becomes difficult.


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Key references

  • Krugman, P. Obstfeld, M. and Melitz, M. (2012) International Economics. 9th ed. Pearson Education Asia.
  • Blanchard, O. (2009) Macroeconomics. 5th ed. Pearson Education.
  • BIS (2006) Annual report 2006. Bank for International Settlements, Basel.
  • “The Big Mac index”. (2018) The Economist.
  • Hill, C. and Hult, G. (2018) Global Business Today, 10th ed, McGraw-Hill. Chapter 10 The Foreign Exchange Market and Chapter 11 The International Monetary System
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