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PURCHASING POWER PARITY THEORY AND EXCHANGE RATE

Purchasing Power Parity Theory and

Exchange Rate

Student’s Name

Professor’s Name

Institution

Purchasing Power Parity Theory and Exchange Rate

Overview of Purchasing Power Parity Theory

Purchasing Power Parity and the Law of One Price

Types of Purchasing Power Parity

Long Run Exchange Rate

Relationship between Purchasing Power Parity and Ongoing Inflation

Relationship between Purchasing Power Parity and Interest Rate

Strengths and Weaknesses of Purchasing Power Parity

Empirical Analysis of Purchasing Power Parity Theory

Relative Purchasing Power Parity

Absolute Purchasing Power Parity

Traded Goods

Non-Tradables

Factors Explaining the Problem with Purchasing Power Parity

Monopolies and Oligopolies

Price Measurement Levels

Consumption Patterns

Price Changes in the Long Run

Price Changes in the Short Run

Conclusion

Reference List

Purchasing Power Parity Theory and Exchange Rate

No nation is rich enough to rely on free gold standard. All countries across the globe have paper currencies that are not convertible into other valuable things including gold. Hence, nowadays nations have standard paper currencies, which complicate exchange situations. In such cases, the exchange rate between two currencies can be measured their purchasing powers. The purchasing power parity theory infers that the rate of exchange between two nations depends on their currencies’ relative purchasing power. In essence, the exchange rate between two nations equals the ratio of their price levels. The purchasing power parity, thus, predicts that a decline in an economies domestic purchasing power due to an increase in domestic prices, will lead to a proportional depreciation of the currency in foreign exchange market (Paul, Kimata & Khan 2

17).

Conversely, purchasing power parity holds that an increase in the domestic purchasing power of a currency will result in a proportional currency appreciation. For instance, if a certain good can be purchased for $1 in the

United States

and 60 rupees in

India

, the purchasing power of$1 in the United States equals to purchasing power of 60 rupees in India. If in the United States $1 can buy a collection of goods that cost 80 rupees in India, then the exchange rate will be $1 equals to 80 rupees. This report tests the validity of absolute purchasing power parity and relative purchasing power by comparing the prices of Van shoes and Fanta orange in the United States and India, and the exchange rates between the two countries.

Overview of Purchasing Power Parity Theory (NEED TO BE PARAPHRASED LOTS OF SIMILARITY WHEN CHECKED IN TURNITIN )

Purchasing power parity theory, at its core, holds that the nominal exchange rate between different currencies is the same as the ratio of aggregate commodity price levels between the two nations. This way, the unit of currency of one nation has the same purchasing power in another country. Purchasing power parity has a long history, dating back many years ago (Pilbeam 2013). The primary idea behind the theory is that a unit of currency ought to buy the same basket of commodities in country A as the equivalent amount of foreign currency buy in country B. Hence, the one unit of currency across the two economies leads to parity in purchasing power.

The simplest means of determining existence of discrepancy in purchasing power parity is to compare the price of identical commodities from the basket in two different nations. For instance, the Economist newspaper normally compares the prices of MacDonaldBig Mac hamburgers around the globe with the United States dollars at prevailing market exchange rates. By doing so, it is easy to ascertain whether or the currency of country A is overvalued or undervalued against the United States’ currency at prevailing exchange rate. For instance, in July 2019, a Big Mac burger was selling at £3.29 in

United Kingdom

against $5.74 in the United States, implying an exchange rate of 0.57. The variance between the 0.57 and the actual exchange rate of 0.80, demonstrates an undervaluation of the British pound by 28.5 percent (Economist 2019).

Purchasing Power Parity and the Law of One Price

The purchasing power parity holds due to arbitrage of international commodities associated with the law of one price. This law asserts that the price of a globally traded commodity should remain the same anywhere around the world as long as it is measured using a common currency. This is due to the fact that people to earn riskless profits by moving commodities from areas with low prices to areas with very high prices. If a similar commodity enters each economy’s market basket used to compute the aggregate price level, the law of one price infers that a purchasing power parity exchange rate must stay true between the two nations concerned (Lee & Yoon 2013). Proponents of purchasing power parity theory contend that the theory valid in the long run and does not law of purchasing power parity.

Even if the law does not hold for each individual good, proponents of the theory posit that prices of goods and exchange rates must not to deviate very much from the relation determined by purchasing power parity. When commodities are more expensive in one nation than in other countries the demand for its commodities and currency declines, which decreases both the domestic price and the exchange rate to equate purchasing power parity. Conversely, cheap domestic products lead to appreciation of currency as well as price level inflation. Purchase power parity, therefore, holds that whether or not the law of one price is untrue, the resultant economic factors will ultimately equalize the economy’s purchasing power in different nations (Krugman, Obstfeld, & Melitz 2012).

Critics of law of one price assert that the existence of transaction costs including transportation costs, tariffs and non tariff barriers, well as taxes, would invalidate the law of one price. In addition, some commodities are not traded between nations and different countries do not attach similar weights to same commodities in aggregate price indices. Moreover, different economies produce differentiated goods and services rather than substitutable products. Also, given that purchasing power parity is anchored on traded commodities, the law of one price can be effectively tested by using producer price indices containing the price of tradable goods instead of consumer price indices (Bahmani-Oskooee & Nasir 2015).

Types of Purchasing Power Parity

Notwithstanding the aforementioned objections, it is always held that the purchasing power parity theory holds due to arbitrage with internationally manufactured goods. Generally, there are two means in which the purchasing power parity hypothesis may hold- absolute purchasing power parity and relative purchasing power parity (Liang 2013). Absolute purchasing power parity remains true when a unit currency’s purchasing power parity remains the same not only in the domestic economy, but also in foreign economy. This can only happen after conversion of the unit currency into the foreign currency at the current market exchange rate. Nonetheless, it is usually challenging to ascertain if the same basket of commodities can be found in different countries.

Hence, it is important to analyze relative purchasing power parity. Generally, this type of purchasing power parity assumes that a percentage change in exchange rate at a given time must offset inflation rate variations between the concerned economies over the same period of time. Generally, if absolute purchasing power parity holds, the relative purchasing power parity must also hold (Zhang & Bian 2015). However, absolute purchasing power parity must not necessarily remain true if the relative purchasing power parity remains true because it is common for nominal exchange rates variances to happen at different purchasing power levels for the two economies (Findreng 2014).

Long Run Exchange Rate

The theory of purchasing power parity, together with money demand and supply relationship, can result in a significant theory of the interaction between exchange rates and monetary factors. Since the factors that do not affect money supply and money demand do not impact this theory, this is usually known as the monetary approach to exchange rate. This approach helps in understanding the long run theory of exchange rates (Al-Gasaymeh & Kasem 2016). The monetary model to exchange rates is a long-run theory since it does not accommodate price rigidities. This is particularly important in understanding short run macro-economic developments (NEEEEEDS TO BE RE PARAPHRASED THERE ARE LOTS OF SIMILARITY HERE WHEN CHECKING ON TURNITIN ). On the contrary, the monetary approach to exchange rate continues as though prices can adjust immediately to maintain not only purchasing power parity, but full employment as well (Abbas Ali, Johari & Haji Alias 2014).

To derive the monetary approach to exchange rate predictions for dollar/rupee exchange rate, it is important to have an assumption that in the long-term, foreign market dictates the rate so that purchasing power parity holds.

Rupee (dollar/rupee) = Price (USA)/ Price (India)————–(i)

It is assumed that the above equation should hold if in the absence of market rigidities to prevent immediate adjustment of exchange rates and prices to positions that are in congruence with full employment.

In the United States;

P (US) = Money supply in US/Long term aggregate money demand in the United States

While in India;

P (India) = Money supply in India/Long term aggregate money demand in India

The long term aggregate money demand falls with an increase in interest rates but also rises with an increase in real output.

Relationship between Purchasing Power Parity and Ongoing Inflation

Although a permanent rise in a nation’s level of monetary supply leads to an increase in its price levels, it does not pose any long run effects on interest rates and real output. Whereas a conceptual examination of a short run money supply change is important in determining the long run impacts of money, it is an unrealistic description of monetary policies. The reasoning is that constant growth in money supply will need an uninterrupted increase in price level or ongoing inflation. Other factors remaining constant, constant growth of money supply leads to ongoing inflation of price levels. Nonetheless, long-run changes in the rate of consumer price index do not affect the long run relative price of commodities or full employment output level (Saadon & Sussman 2018).

Link between Purchasing Power Parity and Interest Rate

Unlike ongoing inflation, there is a negative relationship between interest rate and long-run monetary supply growth rate. Whereas the long-run rate is independent of absolute monetary supply levels continuous increase in monetary supply affects interest rate (Taylor & Sarno 2004). The interest parity infers that if people expect the relative purchasing power parity to be true, the variance between interest rates provided by currency deposits of different countries must balance the difference between expected interest rates existing between the two countries.

Strengths and Limitations of Purchasing Power Parity

The primary strength of purchasing power parity is that it always remains stable over long duration. The relative purchasing power parity, in particular, proves that exchange rate should equal purchasing power parity in the long-run. The outcome can be attributed to a decline in inflation rates between two countries. It also corrects trade imbalances between a country’s imports and exports. There is need to erect trade hindrances which may distort markets. But, economists can easily correct the imbalance by observing the difference between a country’s purchasing power and strength of currency. Readjusting the currency of a country to equate purchasing power can easily solve the issue without government involvement. Purchasing power parity also explains factors affecting balance of payment. It indicates that trade and payment between economies change due to variations in relative price levels of concerned economies. Thus, in the long run, exchange rates are hinged on relative prices and changes in prices.

Nonetheless, conditions relating to prices and tariffs tend to change all the time hindering people’s ability to arrive at a stable conclusion regarding exchange rates. The purchasing power parity can only apply to a static world, but the world is dynamic. This is because, with time, the exchange rate will rise while price level continue decline leading to a situation where exchange rate is greater than price levels. Rose, Marquis and Lu (2012) indicate that internal prices and production costs are always changing. Hence, a new equilibrium between two different currencies changes on daily basis. Differences in two nation’s economic performance, especially in relation to transport and tariffs, can deviate normal exchange rates to certain levels from a currency’s intrinsic purchasing power. The exchange rate of a nation’s currency will rise while its price levels will remain constant if it decides to raise its tariffs. Shapiro (2014) indicates that purchasing power parity can only hold in the case of prices of commodities entering into foreign trade. It is illogical to apply the theory for general indices because of the lack of any relationship between domestic and international prices of products confined to domestic markets. The other limitation of the theory is that it does not take into account other balance of payments items instead of merchandise trade. This implies that the theory only works for current account transactions but not for capital account transactions.

Empirical Analysis of Purchasing Power Parity Theory

Overall, the absolute and relative purchasing power parity theories do not effectively explain the relationship between actual exchange rate data and price levels. Relative purchasing power parity, which is always considered a reasonable estimation to exchange rate data well for a given duration. An analysis of figure 1 demonstrates strengths of relative purchasing power parity by plotting the United States dollar against Indian rupee exchange rates, Erupee/$, and the ratio of India’s and the United States price levels, Pindia/Pus, between 2000 and 2018.Price levels are illustrated by indexes reported by both the Indian and the United States governments.

Relative Purchasing Power Parity

In this relative purchasing power parity I’m assessing the United States/India monthly exchange rate data from 2000 to 2018 and test if the theory holds or not. I chose May 2010 as a base year because of the Global Financial Crisis of 2007 to 2011. Elliot (2011) indicates that May 2010 is the time at which the world decided to switch focus from the private sector to public sector to address the crisis. The effects of the financial bubble affected the economy of all countries around the world, whether or not the economy participated in the risky behaviors that provoked the boom and decline cycle.(more information about how this crisis affected the economy of the 2 countries ?) The relative purchase power parity predicts that Erupee/$ and the ratio of India’s and United States’ price levels will move proportionately, which holds.
Even if there are significant deviations from 2000 to 2010, exchange rate and purchasing power parity moved in the same direction to converge at 45.769. This is because, whereas the price of same commodity in the United States was increasing at higher rate, the prices increased at a smaller margin in India. For instance, The United States’ consumer price index increased by 34.137 while India’s consumer price index increased by 12.84 between January 2000 and 2007. Between January 1, 2007 and May, 2010, the United States consumer price index increased by 13.85 while India’s consumer price index increased by 17.214, leading towards convergence of exchange rate and purchasing power parity.

PLEASE BE CRITICAL AND SHOW ME YOUR UNDERSTANDING

YOU HAVE TO BE CRITICAL AND PROFESSIONAL IN EXPLAINING THIS PART IS SHOWS THE KNOWLEDGE OF TESTING THE

PPP

RELATIVE THEORY ? HOW THE REAL WORDS EXPLAIN WHAT THE THEORY SAID ?

What is the relationship between exchange rate and PPP EXPLAIN IN DETAILS how is the theory explaining that ?

Explain graph one Before base year: explain in details what happened to the economy explain ?

What happended to the exchange rate ?

?What happened to PPP ? how was the relation between PPP AND EXCHANGE RATE BEFORE THE global crisis.WAS OVER VALUED ? OR UNDERVALUED ?

Graph 1 :After base year and crisis: how the relationship between PPP and exchange rate changes how the crisis made this changes … how the prices of goods where effected ?

This graph you are explaining the relation between Exchange rate and PPP SO focus on any important information you tell me the number and the history behind the number ?

TheN you title the second graph deviation

And you start explaining that there was deviation ?

YOU EXPLAIN THE MAIN POINTS THAT ARE IN THE GRAPH

From 2002 there was a decrease what happened in that year to make this decrease //….what is the history that made the deviation in the countries

Then 2005 there was slightly increase until 2016 what happened in that year to make this increase ? history made the deviation in the countries

From 2007 there was a decrease what happened in details same goes for 2009-2011 what happendded here ?and you should end up by explaining the most important point of the deviation graph in a critical way ….history in the countries made the deviation

What is the relationship of this deviation with PPP

After May 2010, the prices of the same commodity increased at rates in both countries. For instance the United States consumer price index increased by 9.933 whereas the consumer price index in India increased by 9.563 between December 2011 and May 2010. However, the consumer price index in India and the United States increased by 27.16 and 9.975, respectively between January 2012 and December 2015. Between January, 2016 and December, 2018 consumer price in the United States and India increased by 14.89 and 12.24, respectively.

Figure 1: the Indian rupee/United States dollar exchange rate and India-U.S price levels
between 2008 and 2018

In the long-run the difference between exchange rate and purchasing power parity declined from 11.634 in January, 2000 to 0.0 in May, 2010. After the base year, there was negative deviation between July, 2010 and October, 2011. Overall, the difference between exchange rate and purchasing power parity oscillated between negative 5 and positive 4.48 from May 2010 and December 2018 (see figure 2). The dramatic deviation from 0.00 on May, 2010 to negative 5.114 can be attributed to significant increase in The deviation can be attributed to the increase in exchange rates as well as the decline in purchasing power parity between the United States and India. Moreover, the prices of same basket of commodities increased at lower rates during the period. The Federal Reserve (2019) indicates that the United States rate of inflation increased from 1.6% to 3.2% between 2010 and 2011 only to decline to 0.1% in 2015. The country’s inflation rate, on the other hand, increased from 0.1% in 2015 to 2.4% in 2018. India’s rate of inflation stood at 10.53% in 2010 before declining to 10% in 2012. From 2012 to 2018, the country’s rate inflation increased to 3.43% in 2018.

Figure 2: deviation between exchange rate and purchasing power parity between 2008
and 2018

Absolute Purchasing Power Parity

To test the effectiveness of absolute purchasing power parity theory, there is need to compare international prices of a large number of baskets of commodities by having necessary adjustments for inter-country quality variations among the identified goods and services. These comparisons normally hold that absolute purchasing power parity is ineffective. The prices of identical goods, when converted into one currency, tend to vary across different economies. According to Çağlayan and Filiztekin (2012), even the law of one price is ineffective in explaining the relationship between purchasing power parity and exchange rate. Since the assertion that leads to absolute purchase power parity theory is anchored on the law of one price, there is no doubt that purchasing power parity is incongruent to the data as evidenced by prices of traded and non-tradable goods in India, the United Kingdom, and the United States.

Traded Goods

In order to assess the validity of absolute purchasing power parity, the local price of Vans men’s Doheny shoes in India, the United States, and the United Kingdom were taken into consideration. This product has been chosen because a trader can export to or import it from one country and still earn some profit. The three countries have been chosen because they have different trade policies, taxation policies, and demand and supply levels. The Vans men’s Doheny shoes costs 2,799 rupees in India,

$54.99

in the United States, and

£35.95

in the United Kingdom (see table 1). When converted to the United States dollars, the product costs $28.17 in the United Kingdom and $39.52 in India. The prices are based on the December 31, 2018 exchange rates between dollar and Indian rupee which stood at

70.83

3, and the exchange rate between dollar and pound which stood at 1.2763.

The differences in the price of the products, when measured in United States dollars, invalidates the absolute purchasing power parity’s assertion that the price of the same good in different economies ought to be equal when measured using a single currency. The difference in the price of Vans men’s Doheny shoes in India, the United Kingdom, and the United States can be attributed to cost of transportation. Regarding transportation cost, American traders must import the product from the other countries making the price of van shoes to cost more than in India and the United Kingdom.

Nation		Local Price		Exchange Rate		Dollar Price	PPP		Value
								of Van Shoes
United States	$54.99		1.00	$ 54.99		1	0
United Kingdom	£35.95		1.28	$ 28.17	0.65	-0.49
India	रु2,799.00	70.8331	$ 39.52	50.90	-0.28

Table 1: Big Mac Index for Van Shoes

Non-Tradables

Just as it is for tradable goods, absolute purchasing power parity is irrelevant for nontradable goods. For instance, whereas a two-liter Fanta orange drink costs

$2.27

in the United States, the same product costs

£1.25

in the United Kingdom and 95 rupees in India. When converted to the United States dollar at the December 31, 2018 exchange rates, the product costs $0.98 in the United Kingdom and $1.34 in India. In the real world it costs more to acquire a two liter bottle of Fanta orange drink in the United States than in India and the United Kingdom, which invalidates absolute purchasing power parity’s assertion. The difference in prices of the same commodity in the three counties can be attributed to such items such as insurance cost, utility costs, as well as labor costs. Generally, the higher the utility cost, cost of insurance, and cost of labor the higher the cost of production.

Nation

Local Price

Exchange Rate

Dollar Price

PPP

Value

United States

1.00

United Kingdom

1.28

India

of 2LT Fanta
$2.27	$ 2.27
£1.25	$ 0.98	0.55	-0.57
रु 95.00	70.83	$ 1.34	41.85	-0.41

Table 2: the Big Mac currency table for Fanta

Factors Behind the Problem with Purchasing Power Parity

There are several factors explaining the negative empirical outcome described above. First, Lee (2010) indicates that contrary to the law of one price assumptions, other factors such as trade barriers and transportation costs exist in trade. These factors may be high enough to hinder trading of goods and services between two countries.

Monopolies and Oligopolies

Existence of monopoly and oligopoly, and trade hindrances can weaken linkages between price levels of different countries. An extreme scenario happens when a single organization decides to charge different prices for a given good or services in different markets. This pricing to market mechanism may result in different demand levels in different nations. For instances, economies characterized with inelastic demand tend to charge higher markup prices over a monopolistic seller’s cost of production. Bastos, Ferreira and Arruda (2018) in an analysis of company level export data found strong evidence of pervasive pricing technique to manufacturing trade markets. In the present report, it costs more to buy a Van men’s shoes in the United States than in the United Kingdom and India, when the price of the product is measured using the United States dollar. This could be due to the fact that there are fewer traders of Vans men’s shoes which hinders the cogency of absolute purchasing power parity. Shifts in demand as well as market structures can violate relative purchasing power parity.

Price Measurement Levels

Different governments across the world have different measures of price levels. One of the primary reasons for the difference in measures of price levels is that residents of different countries always spend their incomes differently. Ghosh (2018) asserts that people tend to consume higher proportions of domestic products, both tradable goods and non-tradable, than foreign made products.

Consumption Patterns

An average Indian is, therefore, more likely to consume more Indian produced Fanta than her American counterpart while an American resident is more likely to consume American produced Fanta than an Indian. As a result it is likely that the Indian government is likely to have relatively high weight on Indian produced Fanta when constructing a commodity basket for measuring purchasing power.

Price Changes in the Long Run

The aforementioned factors associated with purchasing power parity’s poor empirical test performance can lead to divergence of national prices in the long run, after all prices have adjusted to their clearing levels. But many prices may take time to adjust fully and any purchasing power parity departures can be greater in the short run rather than in the long run (AbuDalu & Ahmed 2013). A depreciation of the Indian rupee against the United States, for instance, makes van men’s shoes in the country less costly relative to similar product produced in the United States.

Price Changes in the Short-Run

Short-run departures from purchasing power parity tend to disappear over time. Even when such temporary purchasing power parity departures are not taken into consideration, the cumulative impacts of some long run trends tend to cause predictable deviations from purchasing power parity for many economies. Choji and Sek (2017) associate this trend with the positive correlation between levels of prices and real income per capita. This is to say that, a pound, when converted into local currency such as Indian rupee at the current market exchange rate performs better in poor nations than in rich ones.

Conclusion

Purchasing power parity theory, especially the absolute one, holds that exchange rate between different currencies is the same as their price ratios, as measured by reference commodity basket prices. However, assessment of tradable and non-tradable goods invalidates the assertion that similar products ought to cost the same in different economies if measured using a common currency. This is attributed to various factors such as demand and supply, government policies, and transportation cost. Absolute purchasing power parity proposes another version of purchasing power parity theory, the relative purchasing power parity, which asserts that percentage changes in exchange rate is the same as the differences in inflation rates. Overall, relative purchasing power parity theory validates the notion that exchange rate should equal price level after a given period of time. Nonetheless, the theory can hold for only a given duration because with time the exchange rate should be greater than the purchasing power parity.

Reference List

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balance: A chronological theoretical review,’ Economics Research International, vol. 2014,
pp. 1-8

AbuDalu, A & Ahmed, EM, 2013, ‘The long and short run forcing variables of purchasing
power parity of ASEAN-5,’ E3 Journal of Business Management and Economics, vol. 4,
no.3, pp.66-81.

Al-Gasaymeh, A & Kasem, J, 2016, ‘Long-run purchasing power parity and exchange rates:
Evidence from the Middle East,’ The International Journal of Business and Finance
Research, vol. 10, no. 2, pp.41-53.

Bahmani-Oskooee, M & Nasir, ABM, 2015, ‘Purchasing power parity and the law of one price:
Evidence from commodity prices in Asian countries,’ Global Economy Journal, vol. 15, no.
2, pp.231-240.

Bastos, FDS, Ferreira, RT& Arruda, EF, 2018. ‘Speed of reversion of deviations of the
purchasing power parity for Brazilian cities,’ Revista Brasileira de Economia, vol. 72, no.1,
pp.26-40.

Çağlayan, M & Filiztekin, 2012,‘The law of one price and the role of market structure,’ Munich
Personal RePEc Archive, no. 36975, 1-38.

Choji, NM & Sek, SK, 2017, Testing for the validity of purchasing power parity theory both in
the long-run and the short-run for ASEAN-5. In AIP Conference Proceedings vol. 1905, no.
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https://doi.org/10.1063/1.5012234

Economist, 2019, ‘Burgernomics: The Big Mac index’, Economist, 10 July, viewed 2 January
2020, https://www.economist.com/news/2019/07/10/the-big-mac-index

Elliot, L, 2011, ‘Global financial crisis: Five key stages 2007-2011,’ Guardian, 7 August,
viewed 10 January 2020,

https://www.theguardian.com/business/2011/aug/07/global-

financial-crisis-key-stages

Findreng, JH, 2014. ‘Relative purchasing power parity and the European monetary union:
Evidence from eastern Europe,’ Economics & Sociology, vol. 7, no 1, pp. 22-37.

Ghosh, J, 2018, ‘A note on estimating income inequality across countries using PPP exchange
rates,’ The Economic and Labour Relations Review, vol. 29, no.1, pp.24-37.

Krugman, PR, Obstfeld, M, & Melitz, MJ, 2012. International economics: Theory and policy,
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Paul, MT, Kimata, JD, Khan, MGM, & Campus, L 2017, ‘Purchasing power parity theory and
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Personal RePEc Archive, no. 72788, pp. 1-17.

PURCHASING POWER PARITY THEORY AND EXCHANGE RATE

Purchasing Power Parity Theory and

Exchange Rate

Student’s Name

Professor’s Name

Institution

Purchasing Power Parity Theory and Exchange Rate

Overview of Purchasing Power Parity Theory

Purchasing Power Parity and the Law of One Price

Types of Purchasing Power Parity

Long Run Exchange Rate

Relationship between Purchasing Power Parity and Ongoing Inflation

Relationship between Purchasing Power Parity and Interest Rate

Strengths and Weaknesses of Purchasing Power Parity

Empirical Analysis of Purchasing Power Parity Theory

Relative Purchasing Power Parity

Absolute Purchasing Power Parity

Traded Goods

Non-Tradables

Factors Explaining the Problem with Purchasing Power Parity

Monopolies and Oligopolies

Price Measurement Levels

Consumption Patterns

Price Changes in the Long Run

Price Changes in the Short Run

Conclusion

Reference List

Purchasing Power Parity Theory and Exchange Rate

17).

United States

and 60 rupees in

India

Overview of Purchasing Power Parity Theory (NEED TO BE PARAPHRASED LOTS OF SIMILARITY WHEN CHECKED IN TURNITIN )

United Kingdom

Purchasing Power Parity and the Law of One Price

Types of Purchasing Power Parity

Long Run Exchange Rate

Rupee (dollar/rupee) = Price (USA)/ Price (India)————–(i)

In the United States;

P (US) = Money supply in US/Long term aggregate money demand in the United States

While in India;

P (India) = Money supply in India/Long term aggregate money demand in India

The long term aggregate money demand falls with an increase in interest rates but also rises with an increase in real output.

Relationship between Purchasing Power Parity and Ongoing Inflation

Link between Purchasing Power Parity and Interest Rate

Strengths and Limitations of Purchasing Power Parity

Empirical Analysis of Purchasing Power Parity Theory

Relative Purchasing Power Parity

PLEASE BE CRITICAL AND SHOW ME YOUR UNDERSTANDING

YOU HAVE TO BE CRITICAL AND PROFESSIONAL IN EXPLAINING THIS PART IS SHOWS THE KNOWLEDGE OF TESTING THE

PPP

RELATIVE THEORY ? HOW THE REAL WORDS EXPLAIN WHAT THE THEORY SAID ?

What is the relationship between exchange rate and PPP EXPLAIN IN DETAILS how is the theory explaining that ?

Explain graph one Before base year: explain in details what happened to the economy explain ?

What happended to the exchange rate ?

?What happened to PPP ? how was the relation between PPP AND EXCHANGE RATE BEFORE THE global crisis.WAS OVER VALUED ? OR UNDERVALUED ?

Graph 1 :After base year and crisis: how the relationship between PPP and exchange rate changes how the crisis made this changes … how the prices of goods where effected ?

This graph you are explaining the relation between Exchange rate and PPP SO focus on any important information you tell me the number and the history behind the number ?

TheN you title the second graph deviation

And you start explaining that there was deviation ?

YOU EXPLAIN THE MAIN POINTS THAT ARE IN THE GRAPH

From 2002 there was a decrease what happened in that year to make this decrease //….what is the history that made the deviation in the countries

Then 2005 there was slightly increase until 2016 what happened in that year to make this increase ? history made the deviation in the countries

What is the relationship of this deviation with PPP

Figure 1: the Indian rupee/United States dollar exchange rate and India-U.S price levels
between 2008 and 2018

Figure 2: deviation between exchange rate and purchasing power parity between 2008
and 2018

Absolute Purchasing Power Parity

Traded Goods

$54.99

in the United States, and

£35.95

70.83

3, and the exchange rate between dollar and pound which stood at 1.2763.

Nation		Local Price		Exchange Rate		Dollar Price	PPP		Value
								of Van Shoes
United States	$54.99		1.00	$ 54.99		1	0
United Kingdom	£35.95		1.28	$ 28.17	0.65	-0.49
India	रु2,799.00	70.8331	$ 39.52	50.90	-0.28

Table 1: Big Mac Index for Van Shoes

Non-Tradables

Just as it is for tradable goods, absolute purchasing power parity is irrelevant for nontradable goods. For instance, whereas a two-liter Fanta orange drink costs

$2.27

in the United States, the same product costs

£1.25

in the United Kingdom and 95 rupees in India. When converted to the United States dollar at the December 31, 2018 exchange rates, the product costs $0.98 in the United Kingdom and $1.34 in India. In the real world it costs more to acquire a two liter bottle of Fanta orange drink in the United States than in India and the United Kingdom, which invalidates absolute purchasing power parity’s assertion. The difference in prices of the same commodity in the three counties can be attributed to such items such as insurance cost, utility costs, as well as labor costs. Generally, the higher the utility cost, cost of insurance, and cost of labor the higher the cost of production.

Nation

Local Price

Exchange Rate

Dollar Price

PPP

Value

United States

1.00

United Kingdom

1.28

India

of 2LT Fanta
$2.27	$ 2.27
£1.25	$ 0.98	0.55	-0.57
रु 95.00	70.83	$ 1.34	41.85	-0.41