Purchasing Power Parity

Topics: Purchasing power parity, Economics, Inflation Pages: 7 (2170 words) Published: March 19, 2011
Purchasing Power Parity, and How it Determines the Value of the Dollar

Course: BBUS 452, International Trade Finance
Professor: Giuseppe Liberatore
Group Members:
Pamella De Lima Ishy
Carlos Guerrero
Ricardo Iraheta Reyes
Ann-Marie Mlinac

Literature Review

“Is Purchasing Power Parity a Useful Guide to the dollar?”
This article was our starting article which gave us the idea of researching the Purchasing Power Parity. It identifies that the Purchasing Power Parity should work in the long run, and that the exchange rates should move towards rates that would balance the prices of an identical basket of goods and services between two countries.

There are two types of Purchasing Power Parity, which are absolute and relative. The absolute Purchasing Power Parity is the “law of one price (Hakkio, 1992). If there are no transaction/transportation costs or trade barriers, identical goods sold in different countries have same price when expressed in a common currency. There are two main assumptions related to absolute Purchasing Power Parity. The first is that arbitrage eliminates price differences and the second is that the prices of goods are relatively identical between countries.

In contrast, the relative Purchasing Power Parity is the idea that goods and services do not have the same prices across different countries (i.e Canada and the U.S) and even in common currencies (i.e. the Euro). The absolute Purchasing Power Parity implies relative Purchasing Power Parity, however it does not work the other way.

The Purchasing Power Parity relies greatly on the “law of one price (Hakkio, 1992). The Purchasing Power Parity is hard to predict in the short term since there are always fluctuations in prices. An example of the Purchasing Power Parity would be that if the “domestic price level increases by 10%, the domestic currency should decrease by 10% (Hakkio, 1992). There is no question that in every theory there are some limitations that may occur. In the Purchasing Power Parity, there are some limits. One limitation would be that not all goods and services are traded therefore causing the issue that all goods are not similar. Imperfect competition also causes issues since the retailers can adjust the prices of the products. A Non-tradable goods-International price differential also creates a large restraint since not all nations will get the same product within the price range.

In conclusion, the Purchasing Power Parity holds during the long term but poorly for the short term. The theory also holds better for countries with relatively higher rates of inflation and underdeveloped capital markets.

“The Validity of Purchasing Power Parity: TAR Panel Unit Root Approach”

This specific article verifies that the Purchasing Power Parity (PPP throughout the paper) is valid in the long term yet in the short term is not. The PPP can be used as a “guide for the external competitive power of a country (Kocaeli & Durmus, 2004).

In general, the PPP is based on the theory that the price of a basket of goods should be equal amongst other countries in terms of each country’s currency. For example, the price of a grocery bag in Mexico should be the same price equivalent in the U.S. For currencies that have a floating exchange rate, the PPP is not suitable for the short term. There are many reasons that the short term PPP will not be applicable. Some of these reasons include; transportation costs, transfer costs, free movement of merchandise, and trade.

There are two types of PPP that are known; absolute and relative. The absolute side has many weaknesses since if the same basket is not used it could cause confrontation (since the products can be somewhat different). Whereas the relative PPP considers the price difference in goods and services related to the inflation rates of two countries during a certain period of time.

“A Co-integration Analysis of PPP”

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