Analyse the Purchasing Power Parity Theory and Discuss Its Applicability

Question Analyse the buy power parity possible action and discuss its applicability In this essay I volition hit the books the scheme of Purchasing tycoon Parity and discuss its applicability. I will begin by explaining the basic concepts of uvulopalatopharyngoplasty. In order to get a deeper understanding of the surmisal I will as well as briefly apprehension on topics much(prenominal) as the Law of One set, the outstanding mack hitice and similar subjects related to the Purchasing Power Parity conjecture. what is more the PPP possibleness will be put in to form and its applicability will be discussed and evaluated using real life story examples.It is indispensable to understand the functions of the PPP theory before giving a exposition to it. The purchasing power parity theory is a measurement that is macrocosm used within the economy to comp argon the currencies of diverse countries and to realise if their currencies are under or over valuated. It is as well commonly used as a measurement to analyze the living standard mingled with cardinal countries. The Purchasing Power Parity theory is developed on the home of the law of single impairment (LOP).The law states that once converted to a common cash, the same good should sell for the same expenditure in different countries. (Kalinda Mkenda, 2001) To give an example of this lets sloppiness all the factors such as taxes, tariffs and transportations costs. The law of one equipment casualty can then be explained with the sideline formula e = PSWE/PUK where e equals the nominal ex budge ordain and P outlay. If I deprave a bike in Sweden for 1000- this actor the same bike should, in theory cost ?100 to buy in UK which gives us a nominal exchange rate of 10.If a bike would sell for any price higher in UK, on that point would be a clear advantage for consumers to go to Sweden to buy bikes (remember that factors such as travelling costs are neglected in this example). Also, i t would be beneficial for traders to go to Sweden and buy bikes and sell them in UK for a profit, as well called arbitrage. However, this kind of activity would slowly drive prices higher in Sweden and humble in UK and in the end resulting in commercialise equilibrium found on the theory of supply and demand (Mankiw & Taylor, 2006).This leads us to the Purchasing Power Parity theory which states that price differences between countries in the yen running game is not sustainable because the market will drive the prices to equilibrium and that a cash must have the same purchasing power in all countries (Mankiw & Taylor, 2006 p. 650). Purchasing Power Parities (PPPs) are currency conversion evaluate that both convert to a common currency and equalise the purchasing power of different currencies. In other words, they eliminate the differences in price levels between countries in the process of conversion. (OECD, 2010) The PPP can be verbalised in either inviolable or relative terms. The absolute theory on measuring exchange range is the one mentioned above and is the theory this paper will mainly focus on. The other version, relative, is base on price movements. (Ong, 2003) It states that the inflation rate between dickens countries must be the same if the exchange rate is going to stay the same.That is, if the inflation in one plain X is higher than the country Y, its exchange rate will depreciate against country Y exchange rate based on the following formula % e = % Inflationx -% Inflationy here e is the change in exchange rate. As stated above, the absolute PPP theory is mainly used as a tool of measuring how a currency is valuated and whether its under or over valuated. One rattling popular way to do this is using the Big Mac business leader (See appendix A) put together by The Economist. The Big Mac index is an index of how much a Big Mac costs in different countries. With this index we can compare the hazarded exchange rate with the existen t exchange rate to how a countrys currency is valued. When we compare the PPP we use a basket of goods which is identical in the analyze countries, in this case our basket is a Big Mac.When doing this we can predict an exchange rate based on the Law of one Price and PPP. When comparing the predicted exchange rate with the nominal exchange rate and this illustrates whether a currency is over or under valuated. Looking at the Big Mac index (See appendix B) we can actualize that Norways currency is over valuated by almost 90% against the American dollar sign. This implies that in the long run the Norwegian Krone is expected to depreciate against the US dollar using the PPP theory. PPP is to a fault being used for comparing different living standards in different countries.If you for example use the gross domestic product per capita you dont quite get an accurate overview of the standards as factors such as living costs and pricing varies between the countries. By eliminating the pr ice differences in two countries and compare the raw price differences we get a clear overview of a countrys living standard. Looking at the data in table 1 (See appendix C), we can see that the difference of gross domestic product per capita between Sweden and UK is about 8500 units, however, by comparing the gross domestic product per capita based on PPP per capita we discover a much smaller difference (1000 units. This suggest that the actual living standard of these two countries are quite similar, something that does not show when comparing GDP per capita which is why using PPP is a violate method than using GDP per capita when measuring welfare as it takes into account differences in prices and purchasing power. (International monetary Fund, 2009) By developing root unit tests that account for both structural change and maintaining a long-run mean or trends Papell and Prodan (2006) argues that in that location is additive evidence that PPP is valid in the long run.Howev er data shows that there can be substantial and long periods of time with divagation from PPP exchange rate for either the relative or the absolute versions. (Pakko and Pollard, 2003) We can describe these variations with a few main explanations, starting off with the assumptions we had to make while explaining the law of one price taxes, tariffs and transportations costs, but also adding a few points such as differentiated goods, pricing to market and non-traded goods. Marrewijk et al , 2006), (Pakko and Pollard, 2003), (Moffat, 2010) One simple reason why the law of one price and PPP fails is that exchange rates are influenced by numerous other different factors than just pricing. The existence of trade barriers and costs is one. any variable that will increase the price in another country such as shipping costs or taxes will neglect the arbitrage opportunity and affect the exchange rates related to the PPP theory.Other important factors to deal out are that when explaining th e law of one price we use a basket of identical goods, in real life however, very few goods are the same and people in different countries consume different goods. Also, some goods cannot be traded across borders real estate, haircuts and carwashes are examples of these, also called non-tradable goods. While a piece of property can be traded, its location cannot be changed, thus, prices of property can vary widely between different locations and we can expect this to account for deviations from PPP. When compute the PPP we also require the markets to be suddenly competitive.If a market is not perfectly competitive some firms whitethorn have more control than others and may use this as an opportunity for price discrimination and regulate the price for an identical good differently depending on the customer (Economist, 2010b) which will also cause the PPP to deviate from its expected value. As we can see by this, the purchasing power parity is a useful theory to use for measuring a countrys expected currency and living standard in the long run as it consider factors that are left out when using data such as GDP per capita or CPI, this way you get a much better perspective of the actual values.The theory has been excessively tested in existential studies with mixed results ( Mac Donald, 1993), (Abuaf, N and Jorion, P, 1990), (Papell and Prodan, 2006), (Patel, 1990). Studies show that in the short-term there can be substantial deviations from the expected PPP and exchange rates related to the previously discussed factors, which makes it limited for predicting exchange rates in the closelipped future. However, this argument illustrates that this theory holds true in the long run when calculating currencies and long term equilibrium.