Relationship between Purchasing Power Parity and Foreign Exchange Movement
Assignment :
Word limit is 2000 words excluding references and
appendix.
– Explain Purchasing Power Parity and show how it
can used to explain foreign exchange rate
movements.
Solution
Relationship between purchasing power parity and foreign exchange movement
Introduction
Purchasing power can be termed as the total amount of goods and services that a unit of
currency can buy. Purchasing power parity (PPP) is an economic theory that assesses prices in
diverse areas using a certain good to compare the absolute purchasing power of different
currencies. Therefore, it can be termed as a theoretical exchange rate that enables individuals to
buy a similar amount of goods and services in every country. There is a significant relationship
between purchasing power and PPP since it influences the movement of goods and services in
different countries. Prices of goods determine consumer behavior making them purchase the
most goods with the least amount of money thus influencing the rate of export and import in a
given country. The behavior coerces the individuals to convert currency into another thus
authenticating the movement of the foreign exchange rate. The objective of this paper is to
analyze how PPP explains the foreign exchange rate.
Purchasing power parity
PPP is an economic term that measures the prices of goods and services in different
nations, it is based on the theory of one price. The theory suggests that, if there are neither
transaction costs nor trade barriers to a certain good, then the prices of that commodity should be
the same in every nation (Muller, 2018). In the same economic ideal, the price of a phone in
Dubai should be equal to the price of the same phone in New York. The law of PPP establishes
the idea of the exchange rates and mostly the exchange rates are based on the US dollar as a
standard unit of exchange. Additionally, according to Guris and Tirasoglu (2018), the relative
PPP is statement was developed as a weaker statement founded on the law of one price. Relative
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PPP covers variations in the exchange rates in the inflation rates. The rate tends to mirror the
alterations of exchange rates closer than PPP.
Tariffs, quotas, and poverty thwart business and purchase of different goods thus making
it a challenge to measure a given good and can cause a substantial error. To make the idea
clearer, PPP theory accounts for the aspect by use of a basket of goods that has many goods with
different quantities. Schmidt, (2016) indicated that the exchange rates are then computed with
the law of PPP as the price ratio of the basket in one nation to the price of the same basket in
another nation. When buying, for instance, one computer, five phones, ten flash disks to stock a
shop in New York and cost 50 USD, then buying the same basket of goods in Dubai can cost 150
Dubai dollars. Then the PPP exchange rate can be said to be 1USD is equals to 3 Dubai Dirham.
Moreover, the theory of PPP develops a notion where all consumers have the same
purchasing power. Langston (2016) depicted that, goods to be chosen tend to closely observe the
law of one price where the value of the PPP exchange rate is reliant on the basket of goods
selected. The goods must be able to be traded easily and must be available in both countries.
Economists who calculate PPP exchange rates used different baskets of goods to develop similar
values even though the value may differ slightly. Occasionally, the market value seems to be
very dynamic since it is influenced by the rates of demand in the two nations. The scenario
makes the PPP exchange rates not to correspond with the market exchange rates in the forex
market. Tariffs and the labor prices Balassa Samuelson theorem contribute to extended-term
differences in the two rates.
In this case, economists tend to depend on the PPP rates rather than the market exchange rates
since the PPP rates are less altered by tariffs making them be more stable. The stability makes
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the PPP rates to be applied in a variety of international comparison including computation of
Gross Domestic Products (GDP) and related income statistics (Popkova et al., 2018). The
numbers are indicated by the label PPP-adjusted. Henceforth, there can be marked alternatives
among those converted through market exchange rates and the purchasing power adjusted
incomes.
Concurring with this, Geary-Khamis dollar, for instance, is termed as the international
dollar. The World Bank 2005 Development Indicators projected that in 2003, 1 Geary-Khamis
dollar was equaled to 1.8 Chinese Yuan by PPP significantly distinctive from the nominal
exchange rate. The divergence developed substantial implications when calculating the GDP of
different nations. The GDP in India per capita, for example, is 1,965 USD and when it was
computed using PPP rates, it was estimated to be 7,197 USD. To mirror the related alterations of
inflation rates and exchange rates, relative PPP can be applied. For this reason, PPP tends to be
more than foreign exchange market rates applicable in the foreign exchange rates movement
(Besley, 2019).
Application of purchasing power parity
When the price of goods increases, the consumer’s inflation adjusted income declines.
Inflation adjusted income is referred by economists as real income. Inflation adjusted income
is a negative effect of foreign exchange movement, because consumers have to exhaust more
money on the goods after the price increase than they had to use before the increase. When the
price of goods subside, it increases real income thus enabling consumers to now spend less on
a goods after the price decline, giving them more purchasing power. The real income effect
influenced by the theory of PPP greatly influence the movement of foreign exchange.
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Henceforth, PPP regulates the movement of foreign exchange by effecting the rate of
inflation in commodity market which is a great determinant of international trade. Based on
this idea, foreign exchange movement will be highly altered due to the changes in prices.
When the prices of baskets of goods increase, it means that the value of the US dollar
decreases and vice versa. As a result, consumers spend less percentage of their disposable
income and hence converting less amount of their money into another currency. The law of
PPP provides market information and consumers react to this information thus effecting rate of
foreign exchange movement.
Additionally, PPP induces the effects of goods substitution when the prices change thus
influencing the rate of foreign exchange. When the prices of goods increase in a nation, the
rate of import and exports change. The business persons have low purchasing power when the
prices increase and demand for more expensive commodities shrink hence heightening the
demand for cheaper commodities. Economists term the theory as substitution effect. When the
prices of machineries rise in Germany, for example, Dubai will stop importing machineries
from Germany and start importing cheaper commodities instead. In this case, Dubai can also
start importing goods from another nation instead from Germany. Besides, Dubai might start
producing the same commodities and seize international trade activities. In other worlds,
international trade effects the rate of foreign exchange movement.
The PPP exchange rates are also applied to compare national production and
consumption in various countries. The rates are also used to compare non-traded goods in the
nations where they are regarded as important, unlike market exchange rates which are used for
certain individual goods that are traded. Gelb and Diofasi, (2016), depicted that the stability PPP
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rates make it more applicable than the forex rates and it is often used when that attribute is
significant. The growth of a nation’s economy is measured using PPP rates. Since market
exchange rates shift from time to time, countries opt to measure their GDP using the PPP rates.
When computing GDPs of Qatar, for example, in Qatar currency and is converted to the France
currency using market exchange rates, the value may shift significantly. Qatar may be recorded
to have higher real GDP than France in one year and have lower real GDP in the next year thus
making it a challenge to reflect the reality concerned with their relative production levels. When
the computation is done using PPP, the false information will be eradicated thus making accurate
inferences. The GDP computed using the principles of PPP based on different living costs and
the associated price levels most often related to dominating the US dollar enhances accuracy in
GDP estimation. Different interest rates, hedging, speculation, intervention by central banks
greatly influence the forex market thus increasing the vitality. A country’s growth influences its
activities in the foreign market hence thus determining rates of foreign exchange conversion.
The PPP rates are also used in exchange rate prediction which is a major source of
information investors operate in the international markets. Market information provides
incentives to the entrepreneurs thus influencing the movement of foreign exchange rates. PPP
rates are applicable since the market exchange rates seem to move in one general direction.
Knowing the direction of the exchange rate is considered profitable in the long run of the
business. According to neoclassical economic theory, the PPP law depicts that the exchange rates
among two currencies are the ones applied in the PPP comparison. The theory implies that the
same basket of goods will be purchased with any of the currency in the two nations with a
similar initial amount of cash. The law applies strongly in the short run than in the long run.
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Laws invoking PPP theory suggest that a fall in one of the currency' purchasing power will lead
to a comparative decrease in that currency appraisal on the forex market.
PPP rates are also applied in official exchange rates analysis especially by the
government in identifying manipulation. Nations with influential government controls on the
economic status often impose official exchange rates making their currency artificially stronger.
In relation, the black market exchange rates are artificially weaker. In such scenarios, the PPP
exchange rate is the most realistic argument basis for economic comparison. Correspondingly,
when exchange rates shift substantially from the long term equilibrium due to speculative
actions, a PPP exchange rate tends to give the best alternative for comparison. In 2011, for
example, Argentina used the Big Mac Index to identify the manipulation of inflation numbers.
Weaknesses of PPP
The main weakness of PPP is the challenge of identifying comparable baskets of goods to
analyze the purchasing power across nations. Unfortunately, countries produce goods district
from that of another country because of the availability of the inputs and the know-how
technique. Besides, the availability of the goods makes it harder to come up with such baskets of
goods because of the tariffs and the associated quotas. Low-interest rates initiate incentives to
operate in the foreign market. Besides, different goods have a different quality in the distinct
nations thus making it hard to indicate the right value to a given good.
Besides, estimating the PPP tend to be complicated based on the fact that nations not only
just differ in a standard price level but also in diverse commodities, for instance, different in
housing prices may be higher than the difference in food prices. Consumption of individuals in
one country essentially consumes more food than the individuals in another country. To make
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efficient analysis, economists ought to use price index to evaluate the cost of baskets of goods
since the purchasing power behavior and goods availability differ across nations (Ma, Li, and
Park 2017). Additionally, the basket of goods representing one economy will vary from the other
country's good. Americans, for example, consume more bread and Indians consume more rice.
The case will differ if PPP calculations used the US as the base and another used China as the
base.
The other weakness associated with PPP exchange rates is the limited number of
countries to be analyzed. The theory only operates using two nations. The PPP rate of countries
A and B will be different from country B and C. Alternatively, the case will be different from
country A and C thus making it a challenge when it comes to multilateral comparison. When
PPP assessments are to be done given various time intervals, accurate accounts ought to be done
of inflationary effects.
The methodology challenge when selecting baskets of goods, PPP may vary because of
the statistical capacity of the two nations. The International Comparison Program (ICP) that
gives the basis of PPP estimates, needs disaggregation of a country's account records on
production, expenditure, and income. Occasionally, not all countries disaggregate their accounts
into the above categories. Besides, it is hard to estimate aspects of prices in the PPP exchange
movements in two distinct countries. The reason behind it is because, for instance, a citizen in
Bahrain consume certain goods. After all, the goods are more commercially available than in
Germany.
Conclusion
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Exchange rates are the value of a given currency concerning another currency. The
government of different nations set the exchange rates by use of central banks to regulate the
operations of the forex market. Foreign exchange rates in the market are significantly affected by
the demand for goods and also the tariffs associated with the goods. Using baskets of goods to
obey the law of one price, PPP rates are used to analyze the foreign exchange movement thus
showing the productivity of the country. PPP rates are also used in costing where different goods
are given their distinct associated cost to create investment incentives. PPP rates are more
efficient than market exchange rates since the PPP rates tend to be more stable than the market
rates. The market rates are volatile because of the inflation and the diverse value of goods in the
analyzed nations. Moreover, the application of PPP theory is hard since the theory demands a
basket of goods for comparison which is not easy to come up with one. The demand for goods in
different nations and commercial availability still makes the law not to be considered.
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