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Purchasing Power Parity Essay Sample

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Introduction of TOPIC


Investment banks and foreign exchange dealers play important roles in the foreign currency markets. For purchasing power parity to hold in the long run, real exchange rates must be stationary. At the heart of the movement of foreign exchange rates is the change in a country’s balance of payments. If purchasing power parity held, then the real exchange rate would always equal one. A country’s exports would always buy exactly the same basket of goods imported from abroad. However, in practice real exchange rates exhibit both short run and long run deviations from this value.

In order to reduce currency risk, foreign exchange markets developed so people can convert their cash to different currencies as they conduct business of personal affairs. Furthermore, because payments across borders can be difficult to enforce and creditworthiness can be hard to assess, elaborate “credit procedures” have developed to facilitate international loans and financing. Commercial banks play a major role in financing and arranging foreign exchange transaction because of their expertise in financing business, checking credit, and transferring money. In addition, investment banks and foreign exchange dealers play important roles in the foreign currency markets. A number of organizations have developed to help reduce some of the risks of international trade.

Regardless, there are types of risks that U.S. firms face when engaging in international trade. Furthermore, a country can run a deficit in its balance of trade and still have a strong currency given the conventional wisdom suggesting that a trade deficit should lead to a decline in a currency’s value. When U.S. manufactures need to buy raw materials, they want to get the best possible deal. Hence they investigate several potential suppliers to determine the availability and quality of materials from each, how long it takes to receive an order, and the total delivered price. Kidwell, Peterson, Blackwell and Whidbee (2003) confirm that, when potential suppliers are not located in the United States, comparisons are more difficult because the valuation process is complicated by at least three factors.

The first problem is that the American buyer prefers to pay for the purchase with dollars, but the foreign supplier must pay employees and other local expenses with their domestic currency. The second difficulty is that no single country has total authority over all aspects of the transactions. Also, countries may have distinctly different legal traditions. For purchasing power parity to hold in the long run, real exchange rates must be stationary. Permanent shocks to them would imply a permanent tendency for the purchasing power of the currencies to deviate from one another. Whether real exchange rates are stationary or non-stationary matters, since the two alternatives are associated with two quite different long-run economic implications (Biing-Shen Kuo, & Mikkola, 2001).

Exchange Rates

Comparing suppliers who price their goods in currency units other than the U.S. dollar is the easiest to overcome. To make such comparisons, the American buyer can check the appropriate exchange rate quotation in the foreign exchange market. As an example of how exchange rates facilitate comparisons, assume that the American manufacturer has to pay $190 per ton for steel purchased in the United States and £116 per ton for steel bought from a British supplier. Furthermore, a Japanese steel company is willing to sell for ¥20,000 per ton. Which supplier should the American firm chose?

If the exchange rate between dollars and pounds is $1.65/£, British steel will cost (£116) x ($1.65/£) = $191.40. At this dollar price, the American firm will prefer to buy steel from the American supplier. If the exchange rate between the yen and the dollar is ¥110/$, the Japanese steel will cost (¥20,000)/(¥110/$) = $181.82 per ton. Assuming that the price quotation of ¥20,000 includes all transportation costs and tariffs, or that the sum of those costs is less that $8.18, the American manufacturer will find it cheaper to purchase steel from the Japanese supplier. Hence the contract will be awarded to the Japanese steel company, and dollars will be exchanged for yen in the foreign exchange market to make the purchase. Eliteman, Stonehill, and Moffett (2012), state that, exchange rates are not constant and are free to move up and down in response to changes in the underlying economic environment.

The Equilibrium Exchange Rate

When the foreign demand for a country’s goods and services increases, the demand for its

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currency will also increase as more people seek to obtain currency to pay for their purchases. The equilibrium exchange rate occurs at the price at which the quantity of currency demanded exactly equals the quantity supplied (Madura 2003). At that rate of exchange (price), participants in the foreign exchange market will neither be accumulating nor divesting a currency they do not wish to hold. The key, therefore, to understanding movements in exchange rates will be to identify the factors which cause shifts in the supply and demand curves for foreign currency.

Balance of Payments

At the heart of the movement of foreign exchange rates is the change in a country’s balance of payments. The balance of payments is a convenient way to summarize a country’s international balance of trade, difference of exports and imports, and payment to and receipts from foreigners. A deficit in the U.S. balance of payments means that collectively, we are paying out more money abroad for imports than we are collecting from foreigners who buy our exports.

For the U.S. balance of payments, all of the transactions are between residents of two countries and the transactions are formally recorded in a set of accounts known as the balance of payments.

Purchasing Power Parity

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services. When a country’s domestic price level is increasing (i.e., a country experiences inflation), that country’s exchange rate must depreciated in order to return to PPP. The basis for PPP is the “law of one price”. In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost $500 in Seattle when the exchange rate between Canada and the US is 1.50 CAD/$.

If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called “arbitrage”) is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries. Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country.

For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large. Previously, we discussed the idea that the theory of purchasing power parity predicts that a given amount of currency should buy the same quantity of goods in every country. That is, every good should have the same price no matter where it is sold; a concept known as the law of one price. Obviously, when the price of a good changes in one country but not another, this law is tested. The theory predicts that this situation will result in arbitrage. International businesses will buy the good where it is cheap now in order to sell it where it is more expensive and make a profit as a result. According to Madura (2003),this arbitrage will result in the nominal exchange rate adjusting, depreciating where the good is more expensive and appreciating where it is cheaper, until both currencies buy the same quantity of the good in both countries again.

This theory explains fluctuations in the nominal exchange rate that ensure stability in the real exchange rate. If purchasing power parity held, then the real exchange rate would always equal one. A country’s exports would always buy exactly the same basket of goods imported from abroad. However, in practice real exchange rates exhibit both short run and long run deviations from this value. There are many critiques of the theory. Some goods cannot be traded easily across borders, making arbitrage difficult or impossible. Other goods are not exactly the same in all countries, making them imperfect substitutes and imposing another obstacle to arbitrage. In addition, trade barriers disrupt the efficient process of arbitrage stipulated in the theory. So, a different theory is needed to explain trade and exchange rates completely.


As economies of the world have become increasingly interdependent in recent years, large multinational companies have grown ever more powerful. For these companies, capital is almost completely mobile, and their approach to financial management is global in scope and sophisticated in technique.

The major risks for a U.S.firm importing goods are currency risk, country risk due to the fact that the exporter is not a citizen and may be from a country with a different legal system, and finally, the difficulty of getting reliable credit information. International capital flows by themselves can cause the value of a currency to rise or fall even though the country has a trade deficit. Exchange rates are affected by both trade flows and capital flows and capital flows can offset trade deficits.

Foreign exchange markets facilitate international trade by allowing firms to compare the cost of foreign goods in the home currency. Without foreign exchange markets, firms would have to engage in barter, which is an inefficient means of conducting international trade.

Biing-Shen Kuo, & Mikkola, A. (2001). How sure are we about purchasing power parity? panel evidence with the null of stationary real exchange rates. Journal of Money, Credit, and Banking, 33(3), 767-789. Retrieved from http://ezproxy.nu.edu/login?url=http://search.proquest.com/docview/195346588?accountid=25320 Dimand, R. W. (2011). Irving fisher’s the purchasing power of money. History of Economics Review, (54), 131-143. Retrieved from http://ezproxy.nu.edu/login?url=http://search.proquest.com/docview/918638796?

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