Question

Consider a U.S.-based manufacturing firm that is considering a move to the United Kingdom. Because the company will be using the British pound in its operations, the management team has hired you to explain the Purchasing Power Parity Theory.

In a 3-page report, you will research the Purchasing Power Parity (PPP) Theory in exchange rate determination. Include the following:

• Discuss how PPP can or cannot be a determinant of currency exchange rate differences among countries.
• If you assume PPP holds, could it help in forecasting the future exchange rate of the British pound?

Answer 1

The purchasing power parity theory enunciates the determination of the rate of exchange between two nonconvertible paper currencies. Although this theory can be traced back to Wheatley and Ricardo, yet the credit for developing it in a systematic way has gone to the Swedish economist Gustav Cassel.

This theory states that the equilibrium rate of exchange is determined by the equality of the purchasing power of two inconvertible paper currencies. It implies that the rate of exchange between two nonconvertible paper currencies is determined by the internal price levels in two countries. There are two versions to the theory:

i. The Absolute Version:

According to this version of the purchasing power parity theory, the rate of exchange should normally reflect the relation between the internal purchasing power of the different national currency units. In other words, the rate of exchange equals the ratio of outlay required to buy a particular set of goods at home as compared with what it would buy in a foreign country. It may be illustrated with an example.

Suppose 15 units of commodity X, 18 units of commodity Y and 20 units of commodity Z can be bought through spending Rs. 1800 and the same quantities of X, Y and Z commodities can be bought in the United States at an outlay of 36 dollars. It signifies that the purchasing power of 25 dollars is equivalent to that of Rs. 1500 in their respective countries. That can form the basis for determining the rate of exchange between rupee and dollar.

The rate of exchange between them:

$36= Rs. 1800

$1= Rs. 50

Rate of Exchange (R)= {(units of A(U_A))/(units of B(U_B))}* {(internal purchasing power of A(IPP_A))/(internal purchasing power of B(IPP_B))}

Since the internal purchasing power is the reciprocal of their country's price index:

Therefore; R= (UA/U_B)* (Price Index of B(P_B)/Price Index of A(P_A))

If U_A=U_B= 100; P_B= 150; P_A= 75

Then, R= (100/100)*(150/75)= 2

Therefore, 1 unit of A= 2 units of B.

The absolute version is, no doubt, quite simple and elegant, yet it has certain shortcomings. Firstly, this version of determining exchange rate is of little use as it attempts to measure the value of money (or purchasing power) in absolute terms. In fact, the purchasing power is measured in relative terms. Secondly, there are differences in the kinds and qualities of products in the two countries.

These diversities create serious problem in the equalization of product prices in different countries. Thirdly, apart from the differences in quality and kind of goods there are also differences in the pattern of demand, technology, transport costs, tariff structures, tax policies, extent of state intervention and control and several other factors. These differences prohibit the measurement of exchange rate in two or more currencies in strict absolute terms.

ii. The Relative Version:

The relative version of Cassel’s purchasing power parity theory attempts to explain the changes in the equilibrium rate of exchange between two currencies. It relates the changes in the equilibrium rate of exchange to changes in the purchasing power parities of currencies. In other words, the relative changes in the price levels in two countries between some base period and current period have vital bearing upon the exchange rates of currencies in the two periods.

According to this version, the equilibrium rate of exchange in the current period (R₁) is determined by the equilibrium rate of exchange in the base period (R₁) and the ratio of price indices of current and base period in one country to the ratio of price indices of current and base periods in the other country.

R₁= R₀*[(P_B1/P_B0)/(P_A1/P_A0)]

In the above expression, R₁ is the rate of exchange in the current period and R₀ is the rate of exchange in the base period or the original rate of exchange. P_B1 and P_B0 are the price indices in country B in the current and base periods respectively. P_A1 and P_A0 are the price indices in the current and base periods respectively in the country A.

To illustrate, it is supposed that the original or base period rate of exchange between rupee and dollar was $ 1 = Rs. 50. The price index in India (country B) in the current period (P_B1) is 150 and the price index in the U.S.A. (country A) in the current period is 75. The price indices of two countries in the base period were 100. Now putting the values in the above formula we get:

R₁=(50/1)*(150/100)*(100/75)= 100

R₁= $1= Rs.100

It shows that rupee has depreciated while dollar has appreciated between the two periods.

If the price level in India (B) has risen between the two periods at a relatively lesser rate than in the U.S.A., the exchange rate of rupee with dollar will appreciate. The dollar on the opposite will show some depreciation.

In a reverse case:

P_B1=120; P_A1= 200 and the base price indices of both the country 100;

Then R₁=(50/1)*(120/100)*(100/200)= 30

R₁= $1= Rs. 30

Thus rupee has appreciated while the dollar has depreciated between the two time periods.

It is, of course, true that the purchasing power parity between the two currencies is determined by the quotient of their respective purchasing power. This parity is modified by the cost of transportation including freights, insurance and other charges. These costs lay down the limits within which the rate of exchange will fluctuate.

The upper limit is called as the commodity export point whereas the lower limit is termed as the commodity import point. These limits are not fixed as the gold specie points. Since the purchasing power parity itself is a moving parity on account of the price variations in the two countries, the limits within which it fluctuates are also of a moving character.

In the above diagram, the purchasing power parity curve is of a fluctuating character. It signifies a moving parity. Along with it, the curves indicating commodity export and commodity import points also fluctuate. The market rate of exchange is determined by the intersection of demand curve DD and supply curve SS of foreign exchange.

The market rate of exchange is OR and the quantity of foreign exchange demanded and supplied is OQ. When the demand for and supply of foreign exchange change, the demand and supply curves can undergo shifts as shown by D₁ and S₁ curves.

Accordingly, there will be variations in the market rate of exchange around the normal rate of exchange determined by the purchasing power parity. The market rate of exchange, however, will invariably lie between the limits specified by the commodity export and commodity import points.

Criticism:

The purchasing power parity theory has met with severe criticism from the economists on the following main grounds:

(i) Direct Functional Relation between Exchange Rate and Purchasing Powers:

This theory assumes a direct functional relation between the purchasing powers of two currencies and the exchange rate. In practice, there is no such precise link between the purchasing power of the currency and the rate of exchange. Apart from the purchasing power, the rate of exchange is influenced by several other factors such as capital flows, BOP situation, speculation, tariff structures etc. The purchasing power parity theory overlooks all these influences.

(ii) General Price Level:

The PPP theory determines the rate of exchange through the indices of general price levels in the two countries. Since the general price level is inclusive of prices of domestically and internationally traded goods, the theory rests upon the implicit assumption that the prices of these two categories of goods vary equi-proportionately and in the same direction in both the countries. But it is often found that the prices of internally and internationally traded goods move disproportionately and sometimes even in opposite directions.

Therefore, critics suggested that the rate of exchange should be related to the price indices based upon the internationally traded goods. According to them, the prices of commodities produced and used only in the home country can have no impact on the foreign exchange rate. Keynes has, however, objected to such thinking. According to him, “Confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism.”

(iii) Problems in the Construction of Price Index Numbers:

The major objection against the PPP theory is concerned with the use of price- indices as the basis for measuring the purchasing power of currencies in different countries. The price index numbers are of different kinds that raises the preliminary problem of the choice of the most appropriate price index.

Another problem is that the price index numbers of two countries may not be comparable on account of difference in base period, choice of commodities and their varieties, averages and weights assigned to different items. Given such diverse problems in the construction of price index numbers in two countries, it seems difficult to have a true measure of the purchasing power parity.

(iv) Relationship between Price Level and Exchange Rate:

The PPP theory suggests that the change in price level is the cause and the change in exchange rate is an effect. The changes in prices induce the changes in exchange rates. The theory repudiates that changes in exchange rates can cause changes in price level. In fact the chain of causation in the PPP theory is faulty and misleading. Depreciation in exchange rate can stimulate exports and restrict imports. The reduced supplies for domestic market are likely to push up prices in the home country.

In foreign country the prices are likely to fall. Thus the exchange rate changes may induce the changes in price level. In this context, Halm pointed out that domestic prices follow rather than precede the movement of exchange rate. In his words, “A process of equalization through arbitrage takes place so automatically that the national prices of commodities seem to follow rather than to determine the movement of the exchange rate.”

(v) Neglect of Capital Account:

This theory can be applicable to only those countries in case of which the BOP is constituted only by the merchandise trade account. It overlooks completely, the capital transactions and hence is not relevant for those countries in case of which the capital account is of prime significance. In this context, Kindelberger remarked that the PPP theory was designed for trader nations and gives little guidance to a country which is both a trader and a banker.

(vi) Presumption of BOP Equilibrium:

In its relative version, the PPP theory presumes that the BOP in the base period was in equilibrium. Given this assumption, the theory proceeds to determine new rate of exchange. Such an assumption may not be true. It may be difficult to locate such a base period because the given country might have been faced with a permanent BOP disequilibrium.

(vii) No Structural Changes:

This theory assumes that there are no structural changes in the factors which underlie the equilibrium in the base period. Such factors include changes in tastes or preferences, productive resources, technology etc. The assumption related to constancy of structural factors is clearly unrealistic and the exchange rate is bound to be affected by the changes in these factors.

(viii) Absence of Capital Movements:

The PPP theory related exchange rate exclusively to the internal price changes in the two countries. It, thereby, assumed implicitly that there were zero capital movements. Such an assumption is completely invalid. The changes in capital flow have significant bearing upon the exchange rate, through their effects upon the demand for and supply of domestic and foreign currencies. The impact of capital movements upon the rate of exchange had been neglected by this theory.

(ix) Neglect of Elasticity of Reciprocal Demand:

Another defect in the PPP theory, exposed by Keynes, was its failure to consider the elasticity of reciprocal demand. The rate of exchange between currencies of two countries is determined not only by changes in relative prices but also by elasticities of reciprocal demand.

(x) No Change in Barter Terms of Trade:

The PPP theory relies upon still another assumption that there is no change in barter terms of trade between two countries. Even this assumption is not valid as there are frequent changes in the barter terms of trade on account of several factors such as supply of exported goods, demand for foreign goods, external loans etc.

(xi) Neglect of Demand and Supply Forces:

The rate of exchange is not influenced only by the relative price changes in two countries. The demand for and supply of foreign exchange are the fundamental forces to determine the equilibrium rate of exchange. These forces are influenced, apart from transactions of goods, also by such factors as capital flow, cost of transport, insurance, banking etc. But the PPP theory gives little importance to the forces of demand for and supply of foreign exchange.

(xii) Neglect of Aggregate Income and Expenditure:

This theory has been found to be deficient by Ragnar Nurkse on the ground that it considers only the price movement as the determinant of exchange rate. The variations in aggregate income and expenditure that can have effect upon the foreign exchange rate through their effect upon the volume of foreign trade were completely overlooked by this theory.

According to him, the PPP theory “treats demand simply as a function of price, leaving out of account the wide shifts in the aggregate income and expenditure which occur in the business cycle (as a result of market forces or government policies), and which lead to wide fluctuations in the volume and hence the value of foreign trade even if prices or price relationships remain the same.”

(xiii) Static Theory:

The PPP theory attempts to determine equilibrium rate of exchange under static conditions such as constancy of tastes and preferences, absence of capital movements, absence of transport costs, no changes in tariff, constant technology, absence of speculation etc. It is highly unrealistic to determine exchange rate with all these over-simplifying assumptions. In the actual dynamic realities, this theory fails altogether.

(xiv) Assumptions of Free Trade and Laissez Faire:

This theory rests on the assumptions of free international trade and laissez faire. It means the government does not resort to tariff or non-tariff restrictions upon trade. Even these assumptions do not hold valid in actual reality. There is frequent use of tariffs, quotas and other controls by the governments in both advanced and poor countries. The restrictions on trade do have a definite impact upon the rate of exchange. It signifies that the PPP theory is completely incapable of determining the rate of exchange in actual life.

(xv) Inexact Theory:

Vanek held the belief that the PPP theory at best could serve as a crude approximation of the equilibrium rate of exchange. With its over-simplifying assumptions, it can neither exactly measure the rate of exchange nor can make a precise forecast of it over future period. In this context Halm commented, “Purchasing power parities cannot be used to compute equilibrium rates or to gauge with precision deviations from international payments equilibrium.”

(xvi) Change in International Economic Relations:

This theory fails to take cognizance of change in international economic relations. If originally trade was taking place between two countries, the appearance of a third country either as a purchaser or as a buyer of a particular commodity can have a significant effect on the volume and direction of trade as well as on demand and supply conditions pertaining to the foreign exchange.

Therefore, this theory is not capable of providing a proper measure of rate of exchange in the more realistic conditions of multi-country trade.

(xvii) Relevant for Long Period:

The PPP theory can be considered relevant only in the long period when the disturbances are of purely monetary character. During 1980’s, the exchange rates were found to deviate from those suggested by the purchasing power parities.

No doubt, there are serious theoretical and practical deficiencies in the PPP theory, yet it is indisputably a highly sensible explanation of rate of exchange in such countries where the price movements have a major impact on the exchange rate.

This theory can explain the determination of rate of exchange not only under inconvertible paper standard but under every possible monetary system. The long term tendency of exchange rate can be stated more appropriately through relative price movements and that underlines the practical importance of this theory.

Empirical Tests of the PPP Hypothesis:

Despite weaknesses of both the absolute and relative versions of the PPP theory, the assumptions of this theory are central to many a model. The empirical studies have been made to assess the validity of the PPP hypothesis. These studies have attempted to deal with three issues.

First, whether the Law of One Price holds and whether it is possible to construct price indices that would follow that law. The studies made in this regard attempted by Isard (1977) and Kravis and Lipsey (1978) have given the conclusion that the Law of One Price does not hold true. They also indicate that changes in exchange rate result in variations in relative prices that make it apparently impossible to construct price indices for which the Law of One Price will hold.

Second, the empirical studies attempt to estimate the generalized form of equation and test whether the parameters differ significantly or not from those predicted by PPP. In this connection, the regression-based studies tend to suggest that the PPP hypothesis is not acceptable in the short term. It may, however, do better in the long run.

Third, the issue is whether or not PPP provides efficient forecasts of exchange rate movements over time. In this regard, the time series are based on more sophisticated models involving interest rates, rational expectations and price levels. They proceed to examine the markets. The evidence, in this context, is conflicting. While Mac Donald (1985) concluded that the market was efficient, Frankel and Froot (1985) arrived at the opposite conclusion.

According to Sodersten and Reed, the empirical evidence related to the PPP, is rather mixed. The evidence on balance is against this theory except in the long run. In their words, “We may therefore feel that we must look at models that embody one or other of the PPP hypothesis with some skepticism.”