ppp theory to correct bop

8/14/2019 Ppp Theory to correct BOP

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J6 .:. lnternationa Economics

. . . . . . ~ ies will be reflected iQ their ~ ~ ~ l a n g : , ~ ~ ~The index. i _change ~ nthe purchusmg power ot c u ~ ~ . ; ; - t h ; ;u r ~ h a s i n gP . E ~ ~ } t y . Q J J h ~ r eIS a change inn1umoerof pnces may be made use o f ~ 0 J " e t e m : u n e. p . . . i l i b r i t ~ mrate o f exchange can be foundprices (i.e. the u r c ~ s i n gpower of : he currenctes), the new eq - - ~ ; - - ~ ...._ . .

out by the folJowing formula. "' .. _... x ~ R = - ......:.:.... -. Pl .

where R :::: Equilibrium e x c h a n ~ e } a t e

Er = J ; : x ~ t ein the reference e ~ o d

p d = Domestic price i n ~ex

p = o r e i g ~:~ ~ u ~ t r y ' sprice .index~ ..

valuation Although the ppp theory has certain t r ~ n g t h s . i thas a number o f a whacks too.Demerits The purchasing power a r i ~ l h ~ o r yis ~ u b j e c t t othe following criticisms:

\ . , I ~ The theory .makes use of he_price index number to measure the changes in e e ~ u ~ l i b r i u mrate ofe x c h a ~ g eand hence the theory 'suffers from he various li.tr. itations of the pnce mdex _ umber.

Z , 2. The compositiuu ...,f the ~ t i ~ m i lincomesmies iri d ~ I E . . o t m t r i ~ sand hence the types ofgoodsand services included in the .hiaex u i t i b c ~ ~ H ~ ; ') .i y--::m 0 1' " f r y . t 0country, r ~ n d e r i n gco P,'irisons on the has is of su.ch index i u m b ~ r sunrealistic. . .-

. ~ ....- .. .3 . The quality of goods and services may vary from country to country. Comparison of prices without

regard to the quality is unrealistic. . 4. The price index .number may include the prices of products which are not internat ionaHy traded

and hence th .e rate of exchange calculated on tl1e basis of such price indices cannot be realistic.l 5. The theory . s rendered further unrealistic by ignoring the cost o f transportation in i n t ~ i n ~ t l o

trade.

s 6. Ano .ther very unrealistic assumption made by the theory is that i ~ t e r n a t i o n a ltrade is free from allbarrters. . . .:.. ..- -_ ..... - ~... . - ~ . c - . - - - . . . . .

_b . 7 . : h e purchasing o w e r ~ a r i t yt h e a ~ignores.the effects of i.lteniational c a p i t ~ l ~ o v e m e n t son theroreign exchange market. Internatwnal capttai m o v e m e n t ~may cau h - h h

F I. . . . se c anges m t e exc ange

rate. orexamp e, If thc;:re ts capital mflow to India from USA th 1 f h . d h d

d ~ . . ' e supp y o t e dollar an t eeman 10r rupees mcreases m the fore1gn exchange market c . . . . .

. of the rupee and depreciation in the value of the dollar. , . ausmg an apprecJatwn m the value

8. Another de(ect of the theory is tl1at it ignores the impact of 1 . F 1 f c 1anges m the exchange rates on the

pnces. or examp e, 1 , as a result of large capita inflows to India 1 . terms of foreign currencies Indian exports may d 1 d ' n d ~ a nCUI]'ency apprectates m. . Jsiia may exceed the d e m a ~ dand may cause a fall c . m ~an as a result, the supply o f goods in

~~ t . ( r:;:.l . . m pnces_ 9 ~\:.he theory does not explaiD the demand for the s 1 fJ.o . . . . . .

. rale is determined largely by demand arld su 1U J m d ~r.e l g n_~ x . c l l a . n ge en the exchange. ppycon thons h .... .

attentiOn to these aspects proves to be uns t . 1~ any t eory that oes not pay adequatea IS actory.



. Foreign Exchange. .

. The purchasing power parity theo t 1 t 1 . . ~ .-

o. : a r t i c u l ~ rrate . . .ry.s ar s ~ l t1 a given rate of x c h a l g ~ ,but fails to expiain howthat p . h o_f exchan&c IS ~ r n v c d~ t Thus, the theory n l yt ~ l l sus how, with a given rateof ..exchange, c. a n g ~ s111 t h ~purchasmg powers of two currencies affect the e x c h a n g ~-rate. .

1 The theory ts based on the wrong t' 1 l . . . . . . . . .assump ton t 1at t 1e elashc1 of demand for 'exports and im}lortstS equal to Untly t .e. lhts theory . . } j } f h . .

__ ~ . 7 . .~ s:aI< on y t .t e exports and 1mports change m t e same p nas the change m P ~ l c e s .B ~ t lth1s IS a very rare occurrence. ,

2 No satisfactory explanation of sl1o t t h . h . . : . . h h _ r erm c .anges m exc ang_e rates 1s provided by t e t eory . ,3. The theory goes contrar; to general experience. Critics point out that tl1ere has hardly been any

case wh _n the .rate of exchange between two currencies has been equivalent to the ;atio of.their .. . .purchasmg powers , . : . . .

. . ..

14. Observers maintain that- :the applicability of the PPP theory .is limited . ~ c a u s ee x c h a n g e - r a t

movements are often ca\ised by ~ e ~ st h ~ t ,by its very nature, is unpredictable. Foreign-exchange r ~ t e shave been viewed to behave similarly' to .asset markets (such . as stock .markets), which i n c o r p o r a t ~new information quickly and a d j ~ s ttheir prices continuously. However,. p r c h a s ~ ~ g

power-panty calculations are based on commodity prices (such ~ s the constimer price index), . . . .which respond sluggishly to changing economic circumstances. To the extent that exchange rates .respond quickly to new information and commoditY prlces respond slowly, deparfure :s fr,om tJ:tepurchasing-power-parity theory will occur. Most eq:momists maintain that other factors .are much more important than relative price ' levels for exchange-rate d e t e r m i n a ~ i o nin the ~ h o r t~ t : l -

6 ,, . . ~

. . : .

rits Despite its many defects and

d e f i c i e n C i e s ~the

p u r c h ~ f i n gpower

p ~ r i t yt l ~ e o r yexposes somevery , important aspects of exchange rate determination.

1. I t indicates the relationship between the n ~ ~ r o ~ L p r i c e J ~ y ~ l s _ s 1 J J . Q _ g c l } l . E ~ a _ t e s ;- - _ . . . . ...;. ' ' ' - - ' ' ' ' . .. . - .,., ..

2. l t explains the state of the trade of a country as well as the nature .ofits balance ofpaym ents at aparticular time. .

3 . . Further, the . theory is applicable, to some extent, t9 all saris of monetary standards. .

Empirical Evidence Empiric;ll data present a mixed pictureregardirig i ~ evalidity ofthe prit lhasingpower parity theory. ' ...

and Exchange Rate PredictionsI t

is pointed out that for many years , the purchasingpo,;er-parity appeared to operate reasonably well . Although precise exchange rate r e d i c t i ~ n sbased onpurchasing -power-parity calculations were not always accurate, nations having highP.r inflation rates didat least experience depreciating currencies . In the .early i980s, however, even this broke down. F o ~e x a m p l ~ ,between 1980 and 1983 the US inflation rate was much higher than Japan's and modes .tlyhigher than Germany's . Nevertheless, the .dollar appreciated against both the yen and the mark duringthis period. 7

PPP and Adjustment in Exchange Rote It is observed t h ~ t ,altl10t1gh the p u ~ c h a s i n g - p o wparity theory is oflimitcd value in the short run, over a sufficiently long period it is possible 'that economic .

forces work to maint



8 : lntlirnational E.corlomics - . . ~ ~ _ : _ _ ~ _ _ : i .; . Th . neans that 50 per cent of he adjustment ' 4 t r year JS I 1power panty was per cen pe fi 4 5 years and 90 percent of the d . . ty occurs a ter ' ~

to war purchasmg power pan Its suggest .that the purchasing- ~

d . b th d f 5 years These resua ~ u s t m e n toccurs Y e en o hange rate i f the adjustmen tpower-parity theory provides a rough approximation o f h ~long-run lexc is of little relevance t

. . . . . f h length 10wever, oprocess .ts analyzed over many years. A tJme honzon o sue ' .decision makers. 8

. h ry provided a point o f reference forand rade .It is found that the purchasing power panty t eo . . 1 idence sb d

the long-run e ~ c h a n g erate in many of the modern exchange rate theories. E m p ~ n ~ ~ev d h : ~that PPP performs better for those countries that .are geographicaJJy close to eac 0 d e ~an . ; ;e elinkages are high. Moreover, p:pp holds better for traded goods compared to n o n - :t ~ aed o o s . a s t ~ ~

for failure ofPPP may be attributed to heterogeneitY in tpe baskets o f goods consJ ere. or dc?n cltikon f d. f rt t 'on cost and other trade tmpe tments

1 eo pnce m tees m vanous countries, presence o transpo a I . .[f rfi : k d the volume o f global capt al flows dunngtan , tmpe ect competition m goods mar et, an mcrease m

t last e ~decades which ~ dto sharp deviation from PPP.9

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ppp theory to correct bop

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