International corporate Finance- Question- ‘ In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage ensures that each good is uniformly priced (in common...

Purchasing Power Parity
A Swedish economist, Gustav Cassel, developed the concept of equili
ium rate of
exchange, popularly known as purchasing power parity theory, (PPP) after the
First World War. ―This theory assert that the relative value of different cu
encies
co
espond to relation between the real purchasing power of each country cu
ency
in its own country.‖ The purchasing power parity theory is based on law of one
price which states in the absence of transport costs and trade restrictions each good
should be uniformly priced (in common cu
ency units) throughout the world, this
will happen because if the price of a security, commodity or asset is different in
two different markets, then an a
itrageur will purchase the asset in the cheaper
market and sell it where prices are higher.
The Purchasing Power Parity theory can be stated in the form of two main
alternatives:
1) Absolute PPP – It prevails if the same
oad basket of goods cost the same.
Let PA and PB be the price of the basket in the local cu
ency in countries A
and B respectively. Let E be the price of country B's cu
ency in terms of the
cu
ency A. Absolute PPP then prevails when PA = EPB in other words under
inconvertible paper standard, the absolute rate of exchange between any two
cu
encies is determined on the basis of their purchasing power in their
espective countries and for Absolute PPP to hold it should come out to be
same.
2) Relative PPP – It prevails if the ratio between two
oadly defined price
indices, one from country A and one from country B, stays constant when
co
ected from changes in the exchange rate. Let PA and PB be two price
indices then relative PPP will prevail if the ration E*(PB/PA) is constant. In
other words, relative PPP prevails if the real exchange rate in terms of two
oad price indices stays constant or relative change in exchange rate stays
constant where relative change in exchange rate between two cu
encies is
proportional to change in relative prices in each country for example,
suppose PA and PB are the price levels in countries A and B respectively, in
ase year 0, R is the exchange rate between the two cu
encies and prices in
two countries change in year 1 to PAA and PBB, respectively. Then the new
exchange rate RR between the two cu
encies can be worked out as
RR = R*[PAA/PA/PBB/PB]
For relative PPP to prevail RR should stay constant.
The absolute PPP is based on comparing the same basket of goods, while relative
PPP is based on comparing two baskets which may differ from country to country
for example consumer price indices. However, if same basket is used in all
comparisons, absolute PPP implies relative PPP. But relative PPP does not imply
absolute PPP.
Because an absolute rate of exchange between any two cu
encies is determined on
the basis of their purchasing power of in their respective countries or is determined
in terms of absolute prices, it is argued absolute version of PPP is unrealistic. For
example, suppose a basket of goods and services can be
ought in USA for $ 600
and in London for £ 300, both cu
encies being inconvertible paper cu
encies.
Then the exchange rate between two cu
encies will be determined as:
$ 600 = £ 300
$ 1 = £ 0.50
As the absolute exchange rate cannot be $ 1 = £ 0.50 because there is cost of
transportation, non trade able goods, sometime tariffs and subsidies. We can
conclude absolute version of PPP is not realistic.
Criticisms of Purchasing Power Parity
Because the purchasing power parity is not totally unrealistic it has been a topic of
interest among economist and had been subject to many empirical tests. In addition
it has also been criticized on the following grounds:
1) The whole sale price index number used in PPP theory does not give an
accurate and relevant measure of purchasing power of a cu
ency in the
context of foreign trade. For determining the purchasing power of a
cu
ency, prices of only internationally traded goods are relevant, not WPI.
Therefore, it does not give a realistic exchange rate.
2) Many service items, for instance, banking, insurance, consultancy, etc. enter
the international transactions. Besides, a large amount of capital transfers
take place between the nations. Such transactions do affect purchasing
power of a cu
ency. But, WPI does not take these transactions into account.
3) Haberler (1936) has pointed out, tariffs, subsidy and embargo cause
significant deviation in the purchasing power of a cu
ency. But such items
are not taken care of in the PPP theory.
4) The change in the exchange rate depends, by and large, on the elasticities of
eciprocal demand for imports and exports. But, PPP theory does not take
this factor into account.
5) The PPP theory assumes that relative price is the sole determinant of
international transactions. This is not true. Changes in the exchange rate...