Purchasing Power Parity Theory Of Exchange Rate Determination Finance Essay

The buying power para theory is one of the most influential exchange rate finding theories, and it is raised by the Swedish economic expert Gustav Cassell ( 1922 ) . The theory is an old, but the most basic theory of exchange rate finding. It is a important footing for authoritiess to explicate economic policies, and some international organisations besides employ the buying power para theory to compare the state of affairs of macroeconomic development among states. For case, the World Bank analyses the PPP and the signifier of capital to bring forth the International Comparison Program study. No uncertainty the effectivity of the policies or studies is based on the premise -the PPP theory is valid in pattern. However, sing the issue – whether the PPP theory is effectual or non is challenged by assorted point of views and trials since it is proposed. A great many of the economic experts have tested PPP theory through different methods, and they have got assorted consequences and decisions. In this essay, the consequences of the econometric trials of the PPP theory will be examined, and through the study, the restrictions of the PPP theory will be pointed out from my position.

The building of the essay is as follows. Section 2 paperss a general reappraisal of literature affecting the past trials of the PPP theory. Section 3 presents the cardinal points and model of the theory, including the cardinal constructs and premises, etc. Section 4 provides the findings after appraising the consequences of the econometric trials, while Section 5 summarises the whole paper.

2. Literature reappraisal of past econometric trials of the buying power para theory

Economists have tested PPP theory for infinite times via assorted sorts of agencies these old ages, but sometimes they get wholly different decisions. For illustration, Froot and Rogoff ( 1995 ) provide the empirical grounds which supports the effectivity of PPP theory, whilst Benigno and Thoenisse ( 2008 ) argue that PPP theory is non valid in pattern. In add-on, the ways of proving have ever been bettering. In the early, the ordinary least squares ( OLS ) arrested development is merely used for proving. Then, they examine whether the PPP theory is a random walk. After that, as the econometric techniques are progressively developing, the clip series ‘ method becomes maturer, and many trial techniques such as the unit root trial and the co-integration trial are widely used. Afterwards, some non-liner theoretical accounts are proposed. Apart from the economic experts employ assorted trial methods, the different periods of clip which are tested is another ground that causes different consequences and decisions.

With the development of clip series ‘ method, the empirical ways to prove PPP theory are frequently under a additive construction. One is the unit root trial, because the public presentation of clip series of the existent exchange rate is badly related to the cogency of the PPP theory, the effectivity can be tested by analyzing whether the existent exchange rate is changeless. Roll ( 1979 ) , Adler and Lehmann ( 1983 ) , Mark ( 1990 ) have all utilised this trial, and the consequence can non reject the void hypothesis that the existent exchange rate is a random walk. The other is the co-integration trial, which is proposed by Engle and Granger ( 1987 ) . It tests whether there is a long-run equilibrium relationship between exchange rate and domestic and foreign monetary value degree. Abuaf and Jorion ( 1990 ) , Pippenger ( 1993 ) have all employed the trial, and the chief statement lies in if the dissimilar Exchange rate systems, monetary value degrees or informations frequence have influence on the long-run equilibrium relationship of PPP.

Dumas ( 1992 ) states that due to the dealing costs, the alteration of exchange rate should be non-linear. Therefore, the traditional unit root trial and the co-integration trial is non appropriate, and they may bring forth mistakes. The analysing of the existent exchange rate behaviors should be under the non-linear construction. In add-on, Chen and Wu ( 2000 ) present the similar point of position through analyzing the non-linear behavior that the existent exchange rate perverts from the PPP theory rate between Japan and the United States via STAR ( smooth passage auto-regressive ) theoretical account.

Taylor and Peel ( 2000 ) point out that the ground why the existent exchange rate perverts from the equilibrium exchange rate, and the equilibrium alteration is non-linear is that under the impact of investors ‘ proficient analysis, the exchange rate does non alter precisely as the fluctuation of the economic foundation.

The non-linear fluctuation may deduce from arbitrage cost, authorities intercession or the implement of investors ‘ proficient analysis. The authorities intercession is largely carried out bit by bit, so the accommodation procedure of the exchange rate is likely to be smooth. The smooth passage autoregressive theoretical account ( STAR ) can depict the accommodation procedure, and at that place have been much literature realise this, proving the fluctuation behavior that the exchange rate perverts from the economic footing via this theoretical account. For case, Sarantis ( 1999 ) , Killian and Talor ( 2003 ) , Paya et Al. ( 2003 ) .

3. The cardinal key points and model of the buying power para theory

The basic thought of the buying power para is that the value of money is determined by its buying power, and the domestic monetary value degree may stand for the buying power of its currency to a certain extent, so the exchange rate is determined by the contrast of different monetary value degrees among states.

The jurisprudence of one monetary value is the stipulation of the buying power para. The jurisprudence of one monetary value means that without taking into history the factors such as dealing costs, the monetary values of tradable goods in different states are indistinguishable in footings of the same currency. That is

pi = S ┬Ěpi* ,

In the interim, the jurisprudence of one monetary value has its ain stipulations: the currency convertibility is in the same grade in different states ; currencies, trade goods, services and capital flows are wholly free ; the information is complete ; there are no dealing costs and duties ; the monetary values of trade goods are wholly elastic.

Based on the jurisprudence of one monetary value, the buying power para theory has some cardinal premises: the international trade is wholly free without any dealing costs such as duties, quotas or revenue enhancements ; all the monetary values of goods alteration in the same scope ; monetary value is the lone factor that influences the exchange rate ; the factor which affects the buying power is simply the measure of money.

The buying power para theory can be divided into two signifiers ; one is the absolute buying power para theory, whilst the other is the comparative buying power para theory. The expression of the absolute PPP theory is

S = P / P* ,

S is the exchange rate ( direct citation ) , P and P* represent the domestic and foreign monetary value degree of an indistinguishable package of goods severally. The absolute buying power para means that when the domestic monetary value degree additions comparatively, the buying power of the domestic currency declines consequently. That is to state, the currency devalues and the exchange rate falls, and frailty versa. While the expression of the comparative PPP theory can be derived from the expression mentioned above,

% -S = % -P – % -P* ,

% -S is the rate of alteration in the exchange rate, % -P and % -P* are the domestic and foreign rising prices rate severally. It says that the alteration rate of the exchange rate peers the difference between the domestic and foreign rising prices rate. Compared with the absolute PPP, the comparative PPP is more valuable, and its informations is easier to obtain.

In drumhead, the buying power para theory is the most influential exchange rate finding theory, and it is based on the measure theory of money, construing the exchange rate behavior from the quantitative point of position. Furthermore, it starts to analyze the issue from the basic map of money ( buying power ) , and is easy to understand. The expression is simple every bit good. Nonetheless, the PPP theory is non a complete theory of exchange rate finding. It does non province the cause-effect relationship between the monetary value and the exchange rate clearly.

4. Empirical findings

Having surveyed the relevant literature, I find that the early classical economic experts emphasise that the monetary value can be adjusted freely through the market mechanism, therefore the theories of exchange rate finding following the spirit of classical school assume that the buying power para is ever right. However, since Keynes suggests that the monetary value and pay are of rigidness, the theories of exchange rate finding which derive from the monetary value rigidness theory imply that the buying power para theory can non keep in the short tally, but it can in the long tally. Because the monetary value degree is the trade good market monetary value while the exchange rate is the monetary value of the capital market, and the accommodation velocity of the capital market is faster than that of the trade good market, the exchange rate can barely make the degree determined by the buying power para in the short term. However, in the long term, in one manus, if the perturbation is impermanent, the influence will bit by bit vanish as the clip goes by, therefore the existent exchange rate may travel back to the equilibrium degree, and the buying power para theory holds. In the other manus, if the intervention is changeless, the existent exchange rate may divert, and the buying power para fails to keep. As a effect, it has reached a consensus that the PPP theory is non valid in the short tally, but in the long tally, it is still a problematic issue.

The past empirical trials to most industrial states have suggested that when the international trades run in an unfastened plenty context, the exchange rate can be described by the PPP theory to a certain extent. Nonetheless, in the existent universe, the degrees of economic development and the economic systems vary in different states. Furthermore, many factors may impact the domestic monetary value such as transportation costs, duties, the uncomplete flow of goods, trade barriers, monopolies, alterations in industrial construction and technological advancement, etc. When these factors play an of import portion in the economic system, the jurisprudence of one monetary value, which is the footing of the buying power para theory, and other relevant premises may neglect to keep.

In the empirical trials, many beginnings of informations are used, but normally they do non supply that what are the specific goods which they use to cipher the buying power para. They utilise different indices, computation methods or samples to bring forth the consequences. In add-on, the indices may non reflect the monetary values of non-tradable goods and services, but the non-tradable goods occupy a considerable portion in the computation of monetary value index, so it may impact the trial consequences. Therefore, the statistical misrepresentation may emerge. We can take different samples of goods or indices to bring forth the delusory result.

Some of the comparative early econometric trials of PPP theory literature tend to use the augmented Dickey-Fuller ( ADF ) unit root trial, Engle and Granger co-integration trial or Johansen co-integration trial. However, due to the deficiency of power of the traditional unit root trial and the co-integration trial, the PPP theory is likely to be non valid. Domas ( 1992 ) suggests that because of the dealing costs, the accommodation behavior of exchange rate should be non-liner. After that, Kapetanios, Shin and Snell ( 2003 ) suggest a new theoretical account ( KSS ) based on the smooth passage auto-regressive theoretical account ( STAR ) . Consequently, the literature which carries out the non-liner trial tends to acquire a positive consequence of the PPP theory. As a effect, from my position, it is merely because that some premises of the PPP theory such as the international trades are wholly free or the monetary value is the lone factor to act upon the exchange rate may neglect to keep under certain conditions, the non-liner theoretical account which has taken into history these factors act uponing the exchange rate behavior is likely to bring forth sensible consequences.

5. Decisions

The buying power para theory is one of the most authoritative exchange rate finding theories, but it can non be supported good by the empirical trials since it was raised. This paper outlines the cardinal constructs and model of the PPP theory, and examines and summarises the past econometric trials of it during decennaries. We find that some cardinal premises of the PPP theory fail to keep in the short tally, and certain elements will impact the effectivity of the theory in the existent economic system of the universe. Besides, the study of the literature suggests that the trial methods and techniques will impact the results, correspondingly, the decisions of the effectivity of the buying power para theory vary every bit good.