Purchasing Power Parity

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A look into the theory of PPP and the price of Coca-Cola throughout the world. In this assignment I am going to look at the theory behind Purchasing Power Parity PPP, and the potential reasons why PPP may not hold. I will then be looking at the value of a can of Coca-Cola in several different countries and demonstrating the variance in price and whether PPP holds, therefore giving an indication on whether or not a currency is over or undervalued in relation to a can of coke. I will also be assessing reasons for this variance and relating this back to the theory. Purchasing Power Parity is based on the “law of one Price” ‘In its simplest form, the purchasing power parity exchange rate can be thought of as the level of the nominal exchange rate such that the purchasing power of a unit of currency is exactly the same in the foreign economy as in the domestic economy, once it is converted into foreign currency at that rate’. Taylor (2003, 437). If this is the case then there is no discrepancy in the price of two goods in two different countries indicating that the exchange rate is efficient and that there is no over or undervaluation of currencies, PPP holds.

If PPP is to hold then the following formula reads true,
Pt = Pt* St
Where Pt is the price level of the domestic currency, Pt* is the corresponding price level in the foreign currency and St denotes the exchange rate. However if this did not balance and Pt is greater, than Pt* St Then the home (foreign) currencies are over (under) valued and vice versa. A real exchange rate can be drawn from PPP. A real exchange rate is the exchange rate that is adjusted by price of the same goods in two different countries; it can be represented as follows: Q = St (Pt*/ Pt)

Where Q is the real exchange rate. The real exchange rate can be used to assess the weakness or strength of a currency. Purchasing Power Parity is a way of looking at whether a currency is over or undervalued. PPP indicates what you can buy in each country for a certain sum of each country’s currency if there is an imbalance then there is a possibility for profits through arbitrage. Looking at the economist review titled ‘How to stop a currency war’ I have found that the Chinese Yuan is grossly undervalued, as a result of this it is putting pressure on foreign markets such as America and Europe. Because of this a tariff protection law has been brought in allowing firms to impose taxes on foreign imports from any countries that have undervalued currencies. As a result this will effectively make America’s economy stronger as their exports become more viable. However, this is a view that is not shared by Matoo and Subramanian. They do agree that undervalued currencies affect the profits of countries of which they trade with, but they state that ‘any such unilateral action would be, by definition, partial and hence ineffective’ Matoo and Subramanian (2009, 4), suggest that if there was a tariff introduced to re-dress the balance of undervalued currencies then it would have negative effects on other economies such as Africa, as their goods would become less attractive. They suggest that the International Monetary Fund (IMF) and the World Trade Organisation (WTO) should work together to co-operate on exchange rate issues so that PPP holds. Further research into PPP indicates that if PPP does not hold then there is opportunity for arbitrage. Wang states ‘Upholding of absolute PPP guarantees the elimination of arbitrage’ (Wang 2009, 33). So as a result if there are arbitrage opportunities through a violation of PPP then there is a possibility to make profits through buying goods in one country and selling them in another, but as Wang states this may only be possible depending on the ‘level of associated costs in the international trading process’ (Wang 2009, 33). This means that although there may be a currency undervaluation like the one above in China, the import taxes and export duties on goods being bought...
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