Global Financing and Exchange Rate Mechanisms - Essay Example

Global Financing and Exchange Rate Mechanisms Purchasing Power Parity/"Big Mac Index" The Purchasing Power Parity principle (PPP) was enunciatedby a Swedish economist, Gustav Cassel in 1918. According to this theory, the price levels (and the changes in these price levels) in different countries determine the exchange rate of these countries currencies. The basic tenet of this principle is that the exchange rates between various currencies reflect the purchasing power of these currencies. This tenet is based on the Law of One Price. The law of one price: The assumptions of law of One Price are: Movement of goods: The Law of One Price assumes that there is no restriction on the movement of goods between countries i.e. it is possible to buy goods in one market and sell them in another. This implies that there are no restrictions on international trade, either in the form of a ban on exports or imports, or in the form of quotas. No Transportation costs: Strictly speaking, the Law of One Price would hold perfectly if there were no transportation costs involved, though there are some transactions which bypass this assumption. No Transaction costs: This law assumes that there is no transaction costs involved in the buying and selling of goods. No Tariffs: The existence of tariffs distorts the Law of One Price, which requires their absence to hold perfectly. According to the law of one price, in equilibrium conditions, the price of the commodity has to be the same across the world. If it were not true, arbitrageurs would drive the price towards equality by buying in the cheaper market and selling in the dearer one, i.e., by two-way arbitrage (Siebert, 2002). The absolute form of PPP: If the law of one price were to hold good for each and every commodity, then it will follow that: Pa = S (AB) X Pb Where Pa and Pb are the prices of the same basket of goods and services in countries A and B respectively. Equation can be rewritten as: S (A/B) = Pa/Pb According to this equation, the exchange rate between two countries currencies is determined by the respective price levels in the two countries. Absolute PPP makes the same assumptions as the Law of One Price. It also makes a few additional assumptions. No transaction costs in the foreign currency markets: It assumes that there are no costs involved in buying or selling a currency. Basket of commodities: It also assumes that the same basket of commodities is consumed in the different countries, with the components being used in the same proportion. This factor, along with the Law of One Price, makes the overall price levels in different countries equal. Though the explanation provided by the absolute PPP is very simple and easy to understand, it is difficult to test the theory empirically. This is due to the fact that the indexes used in different countries to measure the price level may not be comparable due to: -- the indexes being composed of different basket of commodities, due to different needs and tastes of the consumer. -- the components of the indexes being weighted differently due to their comparative relevance, -- different base years being used for the indexes. Due to these reasons, these price indexes cannot be used to evaluate the validity of the theory. The relative form of PPP: The absolute form of PPP describes the link between the spot exchange rate and price levels at a particular point of time. On the other hand, the relative form of PPP talks about the link between the changes in spot rates and in price levels over a period of time reflect the changes in the price levels over the same period in the concerned economies. Relative PPP relaxes a number of assumptions made by the Law of One Price and the absolute PPP. These are: Absence of transaction costs Absence of transportation costs Absence of tariffs. The relaxation of these assumptions implies that even when these factors are present, in certain conditions the relative PPP may still hold good. The relative form can be derived from the absolute form in the following manner: Let S (A/B) denote the percentage change in spot rate (expressed in decimal terms) between currencies of countries A and B over a year, and Pa and Pb denote the percentage change in the price levels (expressed in decimal terms), i.e. the inflation rates in two countries over the same period of time. If Pa = S (A/B) * Pb Then, at the end of one year, Pa (1+Pa*) = S (A/B) {1+S* (A/B)} X Pb (1+Pb*) Here the left hand side of the equation represents the price level in country A after one year, the first term on the right-hand side of the equation represents the spot exchange rate between the two currencies at the end of one year, and the last term gives the price level in country B after one year. These terms are arrived at by multiplying the figures at the beginning of the year by 1 plus the percentage change in the respective figures. Dividing by we get, (1+Pa*) = {1+ S* (A/B)} X (1 +Pb*)} We can rewrite the equation as: 1+S* (A/B) = 1+Pa*/ 1+Pb* -> S (A/B) = (1+Pa*/ 1+Pb*) - 1 -> S (A/B) = Pa* - Pb* / 1+Pb* Equation represents what is advocated by the relative form of the Purchasing Power Parity principle. According to the equation, the percentage change in the spot rate (A/B) equals the difference in the inflation rates divided by 1 plus the inflation rate in country B. The Expectations for of PPP: According to this form of PPP, the expected percentage change in the spot rate is equal to the difference in the expected inflation rates in the two countries. This theory assumes those speculators are risk-neutral and markets are perfect. Let the expected percentage change in the spot rate be denoted by S* (A/B), the expected inflation rate in country A by Pa*, and the expected inflation rate in country B by Pb*. If a person buys the underlying basket of commodities in country A and holds it for one year, he can expect to earn a return equal to the expected inflation rate in the country A, i.e. Pa*. On the other hand, if he decides to buy the same baskets of commodities in country B, holds it for one year, and then converts his returns in currency B into currency A {S* (A/B)}, his expected returns will be equal to the expected inflation rate in country B, i.e. Pb*, plus the expected change in the spot rate. If the speculators are risk-neutral, as this theory assumes, then those two returns should be equal, i.e. Pa* = Pb* + S* (A/B) -> S* (A/B) Pa* - Pb* Equation is called the expectation form or the efficient markets form of PPP. As can be observed, it is similar to equation, with all the variables being expressed in expected terms. The role of PPP: Purchasing Power Parity is an important and recurrent concept in international finance. Several theories of the balance of payments and of the exchange rate deploy it in one way or other. The theory of purchasing power parity says that the same goods or basket of goods shall sell for the same price in different countries when measured in a common currency. Purchasing power parity has been used as a theory of the price level: if the exchanged rate is fixed and the home country is small, foreign prices P*will determine domestic prices. Alternatively, purchasing power parity has been widely used as a theory of the exchange rate, whereon rearranging the above equation S = P/P*. One version of the "monetary approach to the exchange rate" keys a theory of the price level, derived from the demand for money function and the money market equilibrium condition, onto purchasing power parity and so derives a monetary theory of the exchange rate. Variants of these models assume that purchasing power parity holds either at all moments of time or only in the long run. The flexible price monetary model is an example that uses the former assumption; while sticky-price models deploy purchasing power parity only as a long-run concept. Reasons for PPP hot Holding Good: Earlier sections mention the assumptions applicable to the Law of One Price and to the various forms of PPP. If any of these assumptions does not hold good, the PPP would also not hold. Besides, even if PPP were actually holding good, the results of an empirical study could get affected by the statistical methods employed. These factors give rise to the following reasons for PPP not holding good: Constraints on movement of commodities Price index construction Effects of statistical method employed. The fact that PPP does not always hold good, gives rise to the concept of real exchange rate. References: Horst Siebert, 2002: The World Economy. Routledge Publishers. ISBN 0415271835 Lawrence H. Officer, 1982: Purchasing Power Parity and Exchange Rates: theory, evidence and relevance. Jai Press. ISBN 0892322292. Moon H... Lee, 1976: Purchasing Power Parity. M. Dekker Publishers. ISBN 0824764501 Read More