The Theory of Purchasing Power Parity - Literature review Example

Literature Review

Global living standard comparisons, poverty and inequality comparisons as well as per capita ranking of countries using their GDP may prompt the conversion rates of a particular currency into the other. The market exchange rates are not considered appropriate in this regard due to their nature of dealing only in tradeable items (Arize, Malindretos and Ghosh 2015).

The PPP (Purchasing Power Parity) is a sophisticated theory in economics. It dwells more on the law that governs one price where assuming an absence of transportation costs and barriers to trade, or else a situation where transportation costs are minimal, the prices of goods with comparable qualities from two different countries articulated under the same currency should be identical (Bahmani-Oskooee and Nasir, 2015). Hence, the PPP theory is enunciated from the law above of the same price where there is an adjustment of the exchange rates in any two countries over a given time to reveal price level changes of the said exchange rates.

The PPP theory has undoubtedly charmed empirical economists all through history with studies of its validity existing with regard to developing and developed countries. These studies have been conducted over diverse periods with some being done on similar sets of nations over different sets of time. Nevertheless, the results have almost always been universal though there is a minimal predictive power of the PPP in the short run. This unpredictability is despite the fact that the theory offers some direction to exchange rates movements over certain periods. However, over the long run, the PPP theory has been known to hold. This provides policy makers with the knowledge that if the price level of a given nation has been on the increase more steadily than that of the other nation, then there is the tendency of depreciation in the currency of the country whose price level is on the increase.

History of PPP

The idea of PPP has a long scholarly history, which dates back to the 16th-century works of scholars from Salamanca University in Spain. Still, contemporary PPP is attributed to Gustav Cassel and is fairly intuitive. In their definition of PPP, Bayoumi and MacDonald (1998) contend that when using the same unit to measure monies of different nations, goods should be from the same category and there should be similar purchasing power. Otherwise, global arbitrage should lead to exchange rates, price adjustments or both for the eventual restoration of parity.

An alternative way to infer the condition of parity is that the ratio of price levels between two nations should be equivalent to the exchange rate between both currencies (Ngama, 1991). However simple it may seem, the parity situation has been the subject of numerous experimental studies due to its critical effects to the global economy. For example, the majority of models in global economics have PPP as their main building block. Hence the policy implications of such models and their relevance critically depend on the PPP’s validity.

Another PPP application is where national income levels are compared. According to Dornbusch (1985), various economists believe that in place of market exchange rates for a meaningful income comparison across nations, PPP exchange rates should be used to control price variances of similar goods across nations. PPP use, however, surpasses academic interest. In a global economy setting, the misalignment of exchange rates is a major cause of capital and trade accounts imbalances. If left unchecked, such imbalances may cause intense stresses for both the global system and individual economies. The national price levels and exchange rates are described by the PPP condition, which is also generally used as a scale for evaluating the misalignment of exchange rates.

Continuous PPP’s Rise and Fall

Following World War II, and the signing of the Bretton Woods agreement, the US dollar was valued with regard to the price of gold and all other currencies followed suit, pegging their value to the US dollar. In 1971 however, President Nixon brought an end to the convertibility of gold and the US dollar and in the process devalued his county’s currency relative to gold (Bergin, Glick and Wu 2009).. Several attempts to reestablish a form of the Bretton Woods agreement bore no fruit, which compelled major world currencies, in 1973 to float against each other. By then, the ‘monetary approach’ was the prevailing approach in determining exchange rates and assumed that the PPP had a continuous hold of the exchange rate.

Proponents of this approach contended that since the exchange rate was the comparative price between two monies, the same comparative price should be governed by the relative balance of demand and supply in the relevant financial markets in asset- market equilibrium.

Numerous empirical studies conducted in the 1970’s examined whether PPP indeed held, including other effects of the exchange rate monetary approach and the preliminary results were positive. With the benefit of retrospection, these positive results could partly have been as a result of a stable dollar during an initial couple of years of the float. More so, according to Beckmann, and Schüssler (2016), since it occurred after a turbulent period and there was not much data to test the theory fully, there was the possibility of missing discrepancies and hence assuming encouraging results.

The US dollar did eventually begin to show signs of volatility during the late 1970’s hence there was the need for more data for the econometricians who consequently proved that the simple monetary approach and the PPP were easily overruled. The ‘collapse’ of the PPP was indeed apparent without the need for being an econometrician as anyone could easily study the real exchange rates’ behavior.

By real exchange rate is meant the foreign currency’s domestic price or the nominal exchange rate multiplied by the (level of domestic prices divided by the level of foreign prices) or the national price level ratios. Since the actual exchange rate measures a foreign currency’s unit’s purchasing power relative to the purchasing power of a similar domestic currency unit in the domestic economy, therefore PPP would, in theory, denote a true relative-price- level- accustomed exchange rate of one. However, Cashin, and McDermott (2001) assert that chances of a nominal rate differing from one are prevalent even when PPP has held.

Practically, if the case at hand is one of cumulative real exchange rates thus cumulative price indices with random base periods, it may be hard to discern when exactly PPP held true to stabilize the real exchange rate that has been measured to unity. Apparently, what can be held as true is the fact that there will be some degree of measured real exchange rate in line with PPP and particularly that there must be an indication of nonconformities with PPP with regard to distinctions in the real exchange rate. Otherwise, there would be constancy where levels consistent with PPP are present.

There was no significant change in the US dollar’s actual trade value between 1974 and 1976. This constancy led to a level of credibility to the unceasing PPP argument. However, the dollar’s real value dropped drastically in 1977 hence; it became obvious that progressive PPP could not hold as it became evident that nominal exchange rates were more unstable than the relative levels of national prices (Chakravarty, and Ahuja, 2016).

Law of PPP and One Price

The LOP (Law of One Price) contends that the prices of similar goods from diverse locations are identical upon exchange rates adjustments. The central argument behind LOP is the global arbitrage. The difference between PPP and LOP is that PPP relates to the index prices of various commodities while LOP represents the real price level of a commodity. LOP is the central building block of PPP in that the PPP situation emanates from the satisfaction of LOP by only one good (Forchini and Peng, 2016). In this regard, PPP could be seen as holding when only one commodity, as opposed to all the commodities, satisfies LOP.

Through various studies that have been conducted on LOP, it has been discerned that the situation does not hold, and there is a substantial variation of deviations across product types. Nonetheless, these studies concentrate more on the sub-indexes of prices such as chemical product prices. Hence rather than examining the absolute LOP, the studies examine the relative aspect of the LOP. Studies involving the use of real individual prices are seldom conducted. The acknowledged price merging in the European vehicle market through the integration procedure, according to Giovannetti (2013) is among the few evidence pieces that are in favor of LOP.

While it is not so easy to find satisfactory proof of the experimental studies, a closer look at the precious metal market shows that the existence of one commodity satisfying the LOP does not have to be an exceptionally stringent condition.

Basics of Assessing PPP

The PPP is arguably the most studied parity condition in global economics. Limited by data constraints, empirical studies usually assess the validity of relative PPP instead of the absolute PPP. Price indexes do not specifically permit an easy evaluation of absolute levels of prices across nations. The choice of indexes of prices is an issue in assessing PPP where the usual choice is between producer and consumer price indexes (Jiang, et al 2016). Certain researchers use the previous index as a substitute for the price index of commodities that are non-tradable and the latter one as a substitution for tradable commodities. Overall, the application of producer price index produces stronger evidence in favor of PPP compared to the application of consumer price index. Additional candidates include price indexes of exports and imports, GDP deflator mechanisms as well as the GDP deflator itself.

The model period used in PPP research ranges from the floating period of post- 1973 to historical models that cover a century or more. There exists a trade-off between long and short samples. Jolliffe and Prydz (2015) contend that long historical samples are advantageous in that they qualify better for long- term trend studies hence for assessing PPP. One disadvantage, however, is that such models cover periods of various exchange regime arrangements including major economic changes that may obfuscate the analysis. In contrast to the long historical models, the post-1973 period may lack sufficient observations to reveal a return to the PPP. However, results from the period following 1973 are the resultant of a more consistent setting and may prove to be more applicable in present policy considerations.

Real Exchange Rate Tenacity

The tenacity of real exchange rate is normally used to deduce the validity of PPP. Real exchange rate becomes constant when PPP is able to hold continuously. In this regard, the verification of an instantaneous PPP that does not hold is quite easy since, in reality, there is no categorical observation of a constant real exchange rate (Kakwani and Son, 2015). Thus, the reason why there is more focus on long-run PPP by the majority of empirical exercises although, under such PPP, there exist short-lived deviations from parity. Nevertheless, the exchange rate and relative price adjust to re-establish the parity condition over time, and the resultant real exchange converges to its rightful equilibrium value.

In light of this, the operational explanation of PPP that is long-run is that there are mean- reverting exchange rates which translate to a mean-reverting behavior test of real exchange rates where the validity of PPP is under test. According to Langston (2016), the mean- reverting characteristic of real exchange rates that lead to the PPP condition is normally tested using root assessment procedures. Certainly, as Yee and Ramirez (2015) contend, the growth of unit- root examination procedures is closely tracked by the evolution of experimental studies where in the 1980’s the emergence of the Dickey-Fuller examination transformed the testing of the persistence of economic data and particularly the persistence of real exchange rate. Since then, various studies have used a flurry of versions of unit root examinations that include; the original (ADF) Augment Dickey-Fuller tests, the Bayesian unit-root examinations, the panel data unit root examinations, the fractional integration tests, processes allowing for different adjustment mechanisms to assess the persistence of real exchange as well as the improved ADF tests version.

Customarily, the persistence of real exchange rate is assessed in a framework that is a linear-time series. If a non-linear path is followed by the real exchange rate, then the level of persistence by the linear model may be overstated using the linear-model (MacDonald and Marsh, 2012). Several non-linear models that include; integration models, models that have structural breaks, threshold autoregressive models as well as Markov switching models have been used in real exchange rate data. Allowance for non-linear dynamics improves the ability to show the return to the PPP while lowering the empirical estimate of real exchange rate tenacity. Considering everything, the PPP has an inclination to hold in the long run more than the short run.

In addition, while complementing findings that are empirically academic, dealers in foreign exchange who double up as determinants of exchange rates in the world market contend that a good measure of the movements in exchange rates are only provided by PPP in the long run (Taylor and Taylor 2004). Of specific significance is the PPP analysis survivorship bias, which denotes the usual practice of examining long historical data from first world countries. Instead of research interest, the practice mainly dwells upon data availability. A particular effect of the bias is that outcomes from countries that are developed may overstate the experimental support for PPP. A relative issue is whether developing and developed countries have the same real exchange rate characteristics. According to Lo, M.C. and Morley, (2015), there is a considerable cross- country heterogeneity in parity deviation persistence, and it is more inclined to encounter parity reversion in developing nations than the developed nations.

A well-known and perplexing regularity is that there is a high level of persistence displayed by real exchange rates as well as a concentrated amount of short-term instability. If the immense short-term instability is attributed to a few central nominal shocks, then the resultant persistence becomes too high for an explanation by price stickiness. Hence the phenomenon ‘PPP Puzzle’. Various theories have been forwarded in an attempt to elucidate the puzzle. One theory alludes that when uncertainty sampling is considered, the likely persistence factor provides a very vague measure of the real persistence (Majumder, Ray and Santra, 2015). Thus, the puzzle is disqualified from being a well-defined puzzle. Subsequent examinations also denote that the projected level of persistence can be abridged to a ‘non-puzzling’ degree upon consideration of adjustment mechanisms that are non-linear in nature.

Economic Factors.

Besides the studies based on time series price data and exchange rate properties, economic factors also play a crucial role in real exchange rate characteristics that are a measure of the deviations of PPP. Probably the most debated economic force that shapes the characteristics of real exchange rate is the Balassa-Samuelson effect. According to Manzur, (2008) the theory dwells on the premise that when using a similar unit, high-income countries project higher price measured levels than their low- income counterparts. The disparity in prices is mainly due to differentials in productivities of both non-tradable and tradable sectors. While government spending acts as a demand-side factor, the Samuelson effect conversely acts as a supply-side factor. Non-tradables are known to account for a huge portion of government spending hence government spending impacts positively on a nation’s real exchange rate. Real exchange rates are similarly affected by additional economic factors such as market structure, the distribution sector and the position of the net foreign asset that was introduced at the beginning of the 21st century to the equation of real exchange rate by means of portfolio-balance channels.

The outcomes of current trade account balances are related to the net foreign asset position that was expressed in the 1980’s and 1990’s.The resulting consequence of the net foreign asset position is shown in various empirical studies although the creation of data on countries’ net foreign assets contains approximations that are all in US dollars (Taylor, 2003). Distribution costs are what affect consumer prices and with the efficiency and productivity of the distribution sector having an impact on the price structure, real exchange rate behavior will also be affected. Naturally, the distribution process takes place within a locality, and chances of it being a non-tradable service are high. The Balassa Samuelson effect asserts that better-quality distribution sector productivity should be related to real exchange rate depreciation. However, the existing empirical evidence signals to a different direction, which may be as a result of tradable elements in the distribution sector. The effect of market structure for the alteration of relative prices to interchange rate movements was documented in the 1980s. Certainly, the market structure has inferences on both the volatility and persistence of real exchange rates. The availability of proper data, however, always poses a hindrance for market structure valuation as the turn of the century brought along encouraging evidence on the effects of market structure that was given using sectoral data.

Inter and Intra- Country Analysis

Normally, both PPP and LOP are identified with the implied assumption that there is a comparison of prices in different countries. However, no reason stands in the way of both parity conditions applying to the prices of similar goods within the same nation. Certainly, the study of relative price characteristics within a particular nation evades the few problems arising from cross-country dealings. For example, the processes of constructing indexes and compiling price data may differ across nations. However, within the same country, such price data is more or less likely to be recorded and collected using one integrated system. Hence, Prodan (2012) asserts that the compatibility of data does not raise serious issues when comparing the prices of similar commodities across regions and cities within the same nation.

Several other reasons make Intra-country data based results easier to understand than those emanating from intercountry data. Primarily, relative Intra-country prices are subject to the same monetary and fiscal policies whereas intercountry related prices may be subject to probably different policies. Secondly, trade barriers present across countries are more complex and severe compared to those present in a country. Further, the Intra country relative prices are linked literally through an exchange rate that has a credible fixing on a one-on-one level hence seldom experience undefined variability in exchange rates. Lothian, (2016) asserts that there is a huge increase in the variability of relative price across national borders thus the implication that Intra-country relative prices of goods that are identical have the capacity to qualify for parity condition. Having these considerations in mind, it is no wonder that Intra-country data, in comparison to intercountry data exhibit a faster convergence rate with a bigger likelihood of fulfilling the parity condition. The end results are reinforced by empirical studies using price indexes or else individual prices of goods.

Conclusion

The income levels of various countries are compared using Purchasing Power Parity all over the world. Hence, PPP allows for easier interpretation and comprehension of each country’s data. When comparing countries that use different currencies, it is imperative to convert values like Gross Domestic Product (National Income) to a common currency. There are two ways to do this. These include the use of PPP’s or market exchange rates. However, the use of market exchange rates may create a couple of problems. Primarily, there is the likelihood of a quick change in market exchange rates, which may translate to a false change in the value of the particular variable like Gross Domestic Product, (GDP). Moreover, the supply and demand of currencies are what determine market exchange rates.

In light of this, the supply and demand of currencies are what reflect the alterations in export and import of traded services and goods. Nonetheless, not all countries trade similar proportions of their output and income; hence, there is no consistent basis to determine currency values. PPP’s are the other option to the use of market exchange rates where the adjustment of rates, considering the differences of the local purchasing power, also known as Purchasing Power Parity adjusted exchange rates, makes the international contrasts more valid. Every three years, the World Bank creates a report that compares nations in terms of US$ and PPP’s. Thus, the use of PPP’s significantly narrows the gap between poorer and richer nations.