Purchasing Power Parity Measurement - Coursework Example

Purchasing –Power Parity (PPP) Measurement Purchasing –Power Parity (PPP) Measurement Introduction Purchasing Power Parity measurement is a concept that has been used to determine both the exchange rate system and the living standards between different countries. It is an economic theory that can be used to assess the value of currency or currencies. Monetary policy has little or lack thereof any impact on the exchange rate system (Oxelheim & Wihlborg, 2008). Purchase Power Parity (PPP) as a measurement of exchange rate The purchasing power parity system allows one to approximate the exchange rate between currencies in a manner that allows the purchasing power of the countries involved being at per. As a theory of rate of exchange, the basic form of PPP is absolute PPP. Absolute PPP is based on the law of box 1. It predicts the adjustment of the exchange rates to being at par with the national basket of goods and services between the involved countries since the market forces are controlled by the desire to make profit due to price difference. In absolute PPP the exchange rate is given by the ratio between the domestic to the foreign price of a given cumulative goods or commodities. Interestingly, the absolute PPP does not hold in practice. It undermines the essence of exchange system. However, if the commodity arbitrage is good then the theory holds (Terjvan, 2008). In most cases countries have different inflation rates. For these countries to bilaterally trade amicably they have to adjust to offset their differentials that emanate from their respective inflation rates. Living standards between countries are compared by modeling the PPP exchange rate. It is achieved by comparing the national prices for vast basket of goods and services. However, the exchange system through this approach may have some disparities as it often proves inadequately accurate. PPP seeks to measure the domestic purchasing power which reflects blatantly on the economic development and the standards of living of the country under examination. The concept is based on the notion that basket of traded goods exhibiting similarities should be valued at the same cost. However, in instances where they are not similar then the disparities or the differences ought to be used to measure national income (Oxelheim & Wihlborg, 2008). Prices of goods and services have been constantly changing. This normally prompts the consumers, businesses, researchers among others to compare and evaluate their income and spending. Comparison of income and measurement of change in income are the right ingredients in evaluating economic development. (Stone et al, 2014). Techniques of Measuring of living standards in economies The most common measure of the living standard is the GDP per capita. It measures the national income. Per capita income in this context refers to the income per individual in an economy. Therefore an increase in GDP per capita consequently leads to the decline in the living standard. The GDP is the widely and wildly used technique of making comparison between economic performances of various countries (Terjvan, 2008). The main challenge with this model is that countries can have similar GDP per capita income but the distribution of these incomes varies from one country to another. In addition, incorporating income generated while working overtime has often proved to be difficult as different countries stipulate different amount of time while working overtime (Terjvan, 2008). Furthermore prices of commodities vary between countries. The purchasing power of a country correlates with the prices of these commodities and the levels of income. When it comes to public goods, it is difficult to determine their true value thus making it difficult if not impossible to compare two countries. These countries may have different spending patterns on these goods and services. The other challenges are the existence of hidden economies as well as conversion of currencies into a common currency in relation to countries with small international trade (Terjvan, 2008). However, the other technique to measure living standard is the application of GDP- Purchasing Power Parity. There are scenarios where some countries have low GDP but the costs of living in these countries are low. PPP factors in these disparities by adjusting appropriately. A slightly accurate technique of measuring the standards of living by factoring in the number of hours worked is the real GDP per capita income per hours worked. If an individual works for twelve hours to gain a higher GDP per capita income while another individual works for less hours to gain the same the GDP the living standards in reference to the first person is less desirable (Great Britain, 2010). As much as most measures of living standards focus on income, consumption of goods or services purchase contribute significantly to ones living standards. In addition, the living standards of a country can be determined by evaluating and analyzing the number of persons living below the poverty line (Stone et al, 2014). Finally, the human development index (HDI) is another measure that highlights options that people in a particular economy have. The HDI incorporates the factors. These factors are the level of literacy, life expectancy and the real GDP per capita income that is adjusted to conform to the cost of living (Oxelheim & Wihlborg, 2008). Benefits of Purchasing Power Parity in economic measurement PPP exchange rate system normally stabilizes with time. This contrasts with the market rate which in most scenarios is volatile. The market rates are only conscious to the internationally traded goods thus neglecting the nontrade goods. In low income countries the nontrade goods are cheaper compared to higher income country. To illustrate further, consider the cost of hair cutting in low income state or country to that of high income state (country). The outcome will illuminate that due to the difference in purchasing power the value nontrade goods are cheaper in low income areas. PPP reduces the chances of misleading comparisons in the exchange rate systems. Because of the stability presented by PPP it measures the welfare of the individuals of the various countries (Samuel et al, 2010). In most scenarios, the ranking using the GDP is normally computed by converting GDP into dollar in the market exchange rate. For instant, a close examination of China and US economy, it was approximated that the US GDP was twice as much as that of China in 2012. This was vindicated by the World Bank statistics. However, critics suggested otherwise since it the measures used did not factor fluctuating exchange rates. The concept of PPP limits China into purchasing other commodities such as ships using PPP currencies (Samuel et al, 2010). Limitations of Purchasing Power Parity in economic measurement The PPP technique is slightly complex in comparison to other techniques such as the market rate system. The statistical nature that is involved is so complex and huge and this fact is further worsened by frequent changes in the prices of goods. The accuracy of the methodology is questionable since in between the surveys the PPP surveys are estimated. Estimation of data is likely to skew information hence resulting into inaccuracy. In addition, the survey does not normally incorporate all countries thus prompting estimation of the missing data. In addition, over long terms, factors influencing prices of trade and nontrade goods in the economy change. This has led to economists criticizing the concept (Samuel et al, 2010). There are several technical problems that crop up while using the PPP measurements. These problems are choice of index in the description of movement of prices; the choice of period; and the option of bilateral and multilateral movement. In the description of inflation, the choice of index plays a key role. These indices numbers are used to measure the inflation of goods or service across the foreign market (trade). However, consumption pattern between different countries complicates the problems in the technique. There is no index that is absolutely perfect in PPP measurement. The sources of the indices are the consumer price index (CPI), the GNP deflator, producer price index, wholesale price index the export price index, and the index that emanate from the labor cost. It is imperative to know that the choice of the index vary when it comes to the measurement of the living standards (Samuel et al, 2010). The GNP deflator is best used when the commodities in question are in a much broader perspective. It however limits in the manipulation of data more frequent than a year. On the other hand, the wholesale price index has proved to cover wide range of traded goods despite complications of statistical challenges. As for export price, it is perceived to be very narrow and that it lacks information concerning prices. Interestingly, the consumer price index (CPI) involves more goods in comparison to the wholesale index but is not part of trade among the trading countries (Samuel et al, 2010). The choice of base period illuminates the foundation of the development of the real exchange rate. The analysis of the base depends on how attractive a country is; foreign exchange market; and the county’s trade balance. As for the choice on the bilateral and multilateral, analyzing deviations of indices from the PPP holistically for the basket of goods and services help in the assessment of devaluation in future (Great Britain, 2010). Conclusion The PPP concept has significantly aided in the measurement of both the exchange rate internationally and the measurements of the living standards. The concept has been beneficial and to some extent destructive to economic measurement. References Oxelheim, L., & Wihlborg, C. (2008). Corporate decision-making with macroeconomic uncertainty: Performance and risk management. Oxford: Oxford University Press. Terjvan, P., (2008). Measuring Living Standards. Retrieved on 23rd Feb 2015 from: http://www.economicshelp.org/blog/180/development/measuring-living-standards/ Samuel, M., et al (2010). Purchasing Power Parity Measures: advantages and limitations. Retrived ov 23rd Feb 2015 from: http://www.odi.org/sites/odi.org.uk/files/odi-assets/publications-opinion-files/6018.pdf Great Britain., & Great Britain. (2010). Private finance projects and off-balance sheet debt: 1st report of session 2009-10. London: Stationery Office. Stone, L. D., et al (2014). Bayesian multiple target tracking. Read More