Parity Theories: Moving Markets to Equilibrium - Essay Example

?Parity theories I. Introduction The parity theories are founded on the assumption that markets move to equilibrium. The more important parity theories are those involving the exchange and interest rates. A basic foundation of the several theories on exchange and even interest rate determination is the theory of purchasing power parity (PPP) that states price levels in two countries will equalize after converting prices into a common currency (Pakko and Pollard 2003, p. 9). PPP theories have long served as the foundation for the theories on international price determination. At the heart of the international parity theories on exchange and interest rate determination is the law of one price. Related to this, the exchange rate is the price of foreign currency in terms of local currency while the prevailing interest rate is taken as the price of capital. Another theory that advances a notion of equalization or parity is the Heckscher-Ohlin theory. The Hecksher-Ohlin theory is composed of two theorems. The first theorem explains and predicts comparative advantage. Ricardo’s theory of comparative advantage assumes but do not explain comparative advantage. The Heckscher-Ohlin Theory’s, particularly the first theorem of the theory, explains comparative advantage to be rooted the in relative factor abundance between nations. The second theorem of the Heckscher-Ohlin theory holds that when there are no restrictions to trade, there will be relative as well as absolute factor price equalisation. Factors of production are land, labour, and capital. The Heckscher-Ohlin asserts, however, that the theory is applicable for labour and capital. The Heckscher-Ohlin theory asserts that with trade liberalisation, mobility of goods can substitute for the mobility of factors and, because of this, relative and absolute factor price equalisation will be realized. Thus, the law of one price and Heckscher-Ohlin theory provides the basic theories that argue that prices among nations will equalize or move to parity if valued in the same currency, exchange rate will reflect the price levels between or among nations, and that factor prices will equalise or move to parity in both relative and absolute terms. The latter can also be cited as one perspective that argues that interest rates will move to parity as interest rates reflect the price of capital which is one of the factors of production and, based on Heckscher-Ohlin theory, mobility of goods substitutes for the mobility of factors and, thus, interest rates also move to parity. II. A main argument against parity theories: markets do not clear There are at least two major areas of the debate on the parity theories. One area of debates is whether markets really move towards equilibrium. Another area of the debate is on the empirical validity of the parity theories: the theories may appear logical but the predictions of the theories and/or their assumptions are not in accord with the situation in the real world. In other words, there are arguments that the theories may be logically constructed but they may not be empirically valid. We discuss empirical validity in the succeeding section and discuss in this section why some economists and critics do not believe why markets do not move towards equilibrium. The perspective or assertion that markets clear is the more conventional and standard assumption in economics. This view is called the classical view (the more modern variants of this view are the neo-classical and new classical perspectives in economics). The classical view is the theory or perspective that is one of the most important building blocks in many theories of economics. However, another perspective that is also conventional but which has a less following in economics today is the Keynesian perspective.1 One variant of the Keynesian perspective asserts that markets do not clear because there are several obstacles to market clearing. It is a perspective that has a significant following and influence among economists. According to this variant of the Keynesian perspective, in the goods market for example, markets do not clear because goods prices tend to be sticky and do not always move to parity because there are also costs associated with changing prices. One such cost in changing goods prices is known as menu costs or the costs associated with changing prices. In the analogy of menu costs, there are costs associated with price changes because restaurants for example, will have to change the prices in their menu and this itself will involve costs as prices are changed. Another possible cost of changing goods prices is that regular customers may shift to other suppliers and an establishment may simply lose goodwill with consumers if the establishment will be the first one to raise prices. Because of these, the prices of goods tend to be sticky or they tend to be inflexible and, thus, they do no always move to parity. In addition, border or trade controls may prevent the movement of goods to areas where the goods are scarce or their movement away from areas where they are in excess supply. Again, this contributes to a situation where the prices of goods do not move to parity across nations. In the labour market, some of the factors and conditions that can prevent international parity on labour prices are the unions, collusion among insiders of an establishment to keep their wages high, and efforts by establishments to have wages that would promote work efficiency or loyalty to the company. These conditions and factors prevent wages to be flexible and, thus, serve to prevent international parity in the wage rates. In the capital market, interest rates or the price of capital are prevented to move flexibly because lenders do not have adequate knowledge on borrowers. Thus, borrowers create systems that involve giving lower interest rates to clients whom they know not to be risky and higher interest rates to clients whom they do not know or whom they perceive to be risky. Thus, a situation is created where there can be multiple prices or interest rates on capital, preventing marketing clearing and the parity of interest rates. From the perspective of PPP, the exchange rates mirror the price levels between two countries. Exchange rates are deemed consistent with law of one price whereby it is held that when goods prices are measured in the same currency, goods prices are equal across countries. Here, the exchange rates measure the general or universal ratio of local prices to foreign prices. This applies when the exchange rate itself is held as the domestic currency price of a foreign currency. It follows that the exchange rate moves towards parity or that the exchange rates equalize regardless of the locality where the exchange rate transaction takes place. As pointed out earlier, however, from a Keynesian perspective, various constraints prevent equilibrium in the market. Exchange rates between two currencies can differ across nations because each country has a specific constraints and policy profile that can directly affect the exchange rate of two currencies. Trade patterns can reflect tastes shaped by history and such trade patterns can directly affect the exchange rates between two currencies. Countries can have traditional trade partners and this can have a strong bearing on the exchange rate. For instance, given an exchange rate between British pounds and American dollars, a country’s history can have shaped a country to favour trade with the British than trade with Americans. Thus, in the country, the value of British pounds in term of American dollars can be higher compared to countries which have a very long history of partnership with the US. In the latter, the British may cost less in term of American dollars. Of course, the scenario will be different if institutional improvements have been such that currencies can move very fast from one country to another. In this case, the exchange rate differentials would move traders to exploit arbitrage leading to equalisation of the exchange rates worldwide. III. Parity theories and evidence 1. Purchasing power parity of the exchange rate One fundamental Purchasing Power Parity (PPP) theory of exchange rate determination is the absolute PPP theory (Salvatore 2001, p. 508). The theory holds that the equilibrium exchange rate between two currencies is equal to the ratio of price levels between the two countries. This can be represented by the following equation (Salvatore 2001, p. 508): R = P/P* where R is the exchange rate and P and P* are the price levels of a country and a foreign country respectively (Salvatore 2001, p. 508). Here R or exchange rate is the local currency price of the foreign currency. It follows from the equation R = P/P* that if PPP holds, commodities will have the same dollar price across the world. Dominick Salvatore explored this issue and produced Table 15.1 for the price of Big Mac, a hamburger product of McDonald’s, in Salvatore (2001, p. 511) which is reproduced as Table 1 of this work. Table 1. Price of Big Mac in April 2000 Country Price in local currency Price equivalent in Dollars United States $2.51 2.51 Australia A$2.59 1.54 Brazil Real2.95 1.65 Britain ?1.90 3.00 Canada C$2.85 1.94 China Yuan 9.90 1.20 Euro Area Euro 2.56 2.37 France FFr 18.50 2.62 Germany DM 4.499 2.37 Italy Lira 4,500 2.16 Spain Pta 375 2.09 Israel Shekel 14.5 3.58 Japan Yen 294 2.78 Malaysia M$ 4.52 1.19 Mexico Peso 20.90 2.22 Poland Zloty 5.50 1.28 Russia Ruble 39.50 1.39 South Korea Won 3,000 2.71 Source: Salvatore (2001, p. 511) It is obvious from Table 1 that data for the prices of Big Mac when converted to their dollar equivalent based on the prevailing exchange rate are not consistent with the predictions of the PPP theory. However, in a 2010 study by Caglayan and Sacildi, the researchers found using Augmented Dickey Fuller Test of econometrics, “the test results show some evidence that stationary real exchange rate series can be taken as evidence supporting the validity of the PPP” theory (p. 138). Caglayan and Sacildi have argued that their tests, results, and conclusions are valid because the Augmented Dickey Fuller Test of econometrics are the usual tests undertaken to test whether exchange rates are stationary (2010, p. 138). According to Caglayan and Sacildi (2010, p. 138), researchers have posited that “if real exchange rates are non-stationary, then the PPP does not hold in the long run” (Callahan and Sacilidi 2010, p. 138). Caglayan and Sacildi have recognized that in most cases of earlier studies, “the existence of unit roots in the real exchange rate could not be rejected and these studies conclude that the PPP does not hold” (2010, p. 138). Caglyan and Sacildi (2010, p. 139) have identified the several studies that do not provide empirical support for the theory of the PPP. In the Caglayan and Sacilidi (2010, p. 140) articulation, the PPP “is a theory that states that exchange rates between currencies are in equilibrium where the purchasing power is the same in each of the two countries”. Caglayan and Sacildi argued that when a country’s domestic price level is increasing then that country’s exchange rate depreciates consistent with the PPP prediction (2010, p. 140). In the Caglayan and Sacildi tests (2010, p 145), 29 countries from the Organisation of Economic Cooperation and Development were covered and their study applied the unit root to test the validity of the PPP. Their empirical tests indicated that the real exchange rates of the 29 OECD countries are stationary which they interpreted their results to mean that the PPP theory is supported by empirical evidence. In addition, to the unit root test they also applied another test called the KPSS test which they believed to be the more efficient test and obtained the similar finding that the PPP is supported by empirical evidence. They went further to argue that the type of the test does not affect results of empirical tests on the PPP. 2. Fischer effect and international interest rates The Fischer effect or relation refers to the relationship between interest rate and the exchange rate in the following form (Dornbusch et al. 2010, p. 535): i = if + ?e/e where i is the local interest rate, if the foreign interest rate, and ?e/e is the expected depreciation of the local currency. Thus, the theory of the Fisher effect says that an expected depreciation will lead to an increase in the domestic interest rate. In Salvatore (2001, p. 527) exposition of the same theory articulated in Dornbusch et al. (2010, p. 534), he used the following equation/notation: i – i* = EA. In the immediately preceding equation, i is the domestic interest rate while i* is the prevailing interest rate in a foreign country. EA is the expected appreciation of the local currency. All values are in percentages. Thus, when the interest differential is 5% that can result if the domestic interest rate is 10% and the interest rate in a foreign country is 5% resulting to 5% from 10% minus 5%, then the local currency is expected to appreciate by 5%. In other words if local interest rate is n% higher than the foreign interest rate, then the local currency is expected to appreciate by n% relative to its exchange rate with another country. 3. Uncovered interest parity (UIP) Salvatore (2001, p. 527) articulated the uncovered interest parity condition as: i = i* + EA - RP. As in the earlier equations articulated in this work, i is the domestic interest rate, i* is the prevailing interest rate in a foreign country, and EA is the expected appreciation of the local currency. Meanwhile, RP is the risk premium that is “required to compensate home-country residents for the extra risks involved in holding the foreign bond” (Salvatore 2001, p. 527). In Salvatore’s example (2001, p. 528), if i=4%, i*=5%, and EA=1%, the risk premium on foreign bond must be equal to 2% to be in uncovered parity. Salvatore (2001, p. 528) argued that if the risk premium or RP is only 1% then it be advantageous for home-country residents to buy more foreign bonds until the interest rate parity condition is satisfied. In investigating the empirical evidence for uncovered interest rate parity, Chinn (2006, p. 7) found that “the evidence against uncovered interest rate parity in the current floating rate era is not as great as is commonly thought” but Chinn also pointed out that “short-term interest differential remains a biased predictor of ex post changes in the exchange rate”. The Chinn (2006) study covered Czech Republic, Hong Kong, Hungary, India, Indonesia, Mexico, Philippines, Saudi Arabia, Singapore, South Africa, Taiwan, Thailand, and Turkey. For these countries, Chinn (2005, p. 17) found that the theory of uncovered interest rate parity applies in the said countries. Chinn (2005, p. 17) pointed out further that interest rate differentials are offset by changes in the exchange rate even as an exchange risk premium can be identified readily in the said group of countries. Korap (2006) introduced a twist on the issue of whether uncovered interest rate parity is supported by evidence. Korap (2006, p. 1) revealed that using co-integration tests, empirical support to the uncovered interest parity hypothesis is provided when integrated with a model supporting purchasing power parity. However, Korap (2006, p. 1) argued that based on his test, the same empirical support of uncovered interest rate parity is not supported when modelling is done independent of the PPP hypothesis. 4. Real interest parity hypothesis (RIPH) Sarmidi and Caglayan (2010, p. 467) made a nice exposition of a theory of worldwide equalisation of real interest rate: “…The real interest rate parity hypothesis (RIPH) states that if economic agents are rational, there are no economic barriers between countries or no differential tax treatment in goods and assets markets, then the real interest rate between countries will equalize.” According to Sarmidi and Caglayan (2010, p. 467), however, several researchers have investigated the RIPH but, contrary to its widespread use as a theory, empirical tests of the RIPH “reject the predicted relation between interest rate differential and exchange rate changes”. 5. Unbiased forward rate in (UFR) in the exchange rate The “unbiased forward rate hypothesis” (UFRH) holds that the forward exchange rate of any currency is an unbiased predictor of the future spot rate of the exchange rate (Kumar and Mukherjee 2007, p. 56). The forward rate of the exchange rate refers to the value of the exchange rate in the future as agreed in a transaction today or at an earlier period. On the other hand, the future spot rate of the exchange rate refers to the value of the exchange rate in the future as they have emerged or decided by the market contemporaneously in that future. Thus, the “unbiased forward rate hypothesis” (UFRH) basically says that what parties agree on the future value of the exchange rate in forward contracts can predict in unbiased way or reliable way the future value of the exchange rate. Kumar and Mukherjee (2007, p. 56) tested the UFRH hypothesis for the Indo-US forex market and found that cointegration tests or regressions confirm the validity of including the forward rate and the current spot rate in predicting the future spot rate of an exchange rate. However, further investigations conducted by Kumar and Mukherjee (2007, p. 56) on the Indian-US forex market do not fully support the UFRH. Nevertheless, Kumar and Mukherjee (2007, p. 60) obtained a relatively good tracking ability of the forward rate to predict the future spot rate. This is indicated by Figure 1 which reproduces the Figure 1 in Kumar and Mukherjee (2007, p. 60). Figure 1. Forward rate versus Future Spot Rate, Indian-US Market, 2000-2007 Source: Kumar and Mukherjee (2007, p. 60) Figure 1 indicates that the forward rate almost coincides with the future spot rate in the Indon-US market as per the study of Kumar and Mukherjee. IV. Conclusion: Parity theories most useful for business All of the theories are useful for business because they indicate the likely movement of exchange rate, interest rate, and price variables. In a globalizing world economy, it is likely that that the UFRH will be one of the most useful parity theories because the theory can enable us to anticipate returns and profitability from exports as well as returns, profitability, and cost impacts from import prices. PPP theory and the law of one price can enable us to anticipate the most likely impact on the exchange rate of price movements. For example, an increase in domestic prices at rates higher than foreign or world prices would most likely signal a depreciation in domestic currency in a very near future. The Fischer effect is also useful because it allows us to anticipate a likely pressure on the exchange rate with a movement in the interest rates based on the rearranged format of the equation ?e/e = i - if . The uncovered interest parity theory deserves our appreciation for factoring in the role of risks in the movement of capital flows. It is likely that parity is not achieved at all but a knowledge of the parity theories enable us to have a grasp of the pressures on the price variables and how price movements can be affected in the short or longer runs. Of course, the prevailing view is that the parity theories are the long-term movements. Most likely, however, long-term parity is not reached because many of the economic variables are volatile. Economies may or may not move towards equilibrium but regardless of what the case is, parity theories can indicate the general movements of variables given movements in the other economic variables. Even if parity is not reached, the situation is understandable because markets are volatile in the first place. At the very least, empirical studies on the parity theories indicate that they have some empirical support. It is not appropriate to have 100% empirical support in the first place because economic variables are highly volatile. For example, it is very difficult to achieve interest rate parity because rumours of war, actual war, rumours of disaster, actual occurrence of disasters, and many other variables can affect the interest rate. References Baumol, W. and Blinder, A., 2009. Macroeconomics: Principles and policy. 11th Ed. London and other cities: South-Western Cengage Learning. Caglayan, E. and Sacildi, I., 2010. Does purchasing power parity hold in OECD countries. International Research Journal of Finance and Economics, Issue 37, 138-146. Chinn, M., 2006. The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets. Journal of International Money and Finance, 25, 7-21. Dornbusch, R., Fischer, S., and Startz, R., 2008. Macroeconomics. 10th Ed. Boston and London: McGraw Hill. Hall, R. and Lieberman, M., 2005. Macroeconomics: Principles and application. 3rd Ed. Mason: Thomson-Southwestern. Korap, L., 2008. Testing international parity hypothesis in a multivariate identified co-integrating system: the Turkish evidence. Munich Personal RePec Archive. Krugman, P. and Obsfeld, M., 2003. International economics. 6th Ed. Boston, London and other countries: Addison-Wesley. Kumar, R. and Mukherjee, S., 2007. Testing forward rate unbiasednes in India: An econometric analysis of the Indo-US forex market. International Research Journal of Finance and Economics, Issue 12, 56-66. Pakko, M. and Patricia, P., 2003. Burgernomics: A Big Mac Guide to purchasing power parity. St. Louis Federal Reserve Journal, November-December, 9-28. Salvatore, D., 2001. International economics. 7th Ed. New York and Brisbane: John Wiley & Sons. Sarmidi, T. and Caglayan, M., 2010. Real interest rate parity hypothesis: Evidence from Malaysia and Thailand. Journal of International Social Research, 3 (14), 467-471. Read More