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Parity Theories - Essay Example

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Parity Theories

This simply indicates uniformity in the prices of fixed number of goods and services and exchange rate of two countries. The roots of this theory lie in the law of one price, which says that homogenous goods should have identical prices universally not including any carrying or shipping costs under the prevalence of perfect competition if the pertinent national prices are stated in a common currency. The law of one price has certain conditions, which must exist in order for this law to be applicable. Firstly, it is the presence of competitive market for goods and services in two countries (EconomyWatch, 2010). Secondly, presence of goods and services that two countries can trade between themselves and lastly, checking of transportation and other operational expenses, which are obstructions in trade. Taking example of McDonald’s Big Mac hamburger prices around the world, one can understand this concept. For this the one should take the prices of all the countries in common currency, therefore dollar would be the appropriate one as every currency’s appreciation or depreciation is measured in terms of dollar (Taylor and Taylor, 2004, pp.135-158). In January 2004, the price of hamburger in United States was $2.80 where as in China it was $1.23, least expensive of all countries, this shows that China’s currency was underrated by 56%. ...
Moreover, wage rate of the person serving foods at restaurant, rent of place of restaurant, and many other factors in case of businesses other that restaurants, have different costs and values in different countries therefore final prices become very different due to these inputs. In response of question that why countries should adopt Purchasing Power Parity Theory when there are so many discrepancies, one can say that in long-term PPP theory has good effects on the economy of a country. A big retailer may use this theory to find that in what countries products possess lesser prices than the domestic country so that the retailer can approach them. This would increase the demand of that product in the country in which it is of low price leading to increase in price (Murray and Papell, 2005, pp. 410-415). Simultaneously, the countries that were selling the product at a higher price would somehow manage to lower the prices so that demand increases and people purchases from them. Ultimately, both countries would start offering same prices in spite of differences in the currencies. There are two types of purchasing power parity theories; these are Absolute purchasing power parity and relative purchasing power parity. Absolute purchasing power parity theory suggests that if the prices of goods convert into same currency then a basket of goods would have same cost in the native country as well as abroad. In simple words, absolute purchasing power parity theory assumes that the purchasing power of money should be identical between countries. On the other hand, relative purchasing power parity theory focuses on changes in ...Show more

Summary

Purchasing power parity theory of exchange rate is based on the idea of equivalence in the purchasing power of countries, which leads to equilibrium in the exchange rate between the currencies of countries…
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