Introduction
Over the years, international trade began with countries engaging cross border economies. Exporting and importing are common practices and have influenced the economies of different markets in different countries. Scholars have engaged in studies to understand the economic trends and foreign exchange.
The rate of inflation and economic changes are some of the interests for the researchers. Reactions to economic change and foreign exchange dynamics have been given attention in their studies. Central banks in different countries have also kept record of the statistics to monitor the inflation rates and the impacts of the changes in the foreign exchange market.
Scholars engage in the studies to obtain knowledge of the factors that affect the international markets and to get insights on how the tension caused by financial market tension impact the economic market. Currencies have different exchange rates depending on their economies. Their purchasing power can be influenced by inflation rates. This paper will discuss purchase power parity. Then it will provide information on the monthly inflation rate of USA and Europe and present their relationship
Purchasing power parity
Definition
In accordance with Suranovic (1), Purchasing Power Parity is an approach for determining exchange rates of utilities involving different economies. The purchasing power for commodities is viewed as similar in different countries when the concept of Purchasing Power Parity is implemented. Importing and exporting activities influenced by price variations affects the exchange rate. The current account transactions of a state impact the foreign exchange.
The cost of commodities between those countries will replicate the exchange rate. Diversity of inflation rates will be equal to the percentage increase or decrease of the rate of exchange. When there is no uniformity in the purchasing power of similar goods in different countries, the national statistical revenue and the GDP can be adjusted to reflect similarity in the entities. The value of a currency should be decreased to enable purchasing power parity to be obtained after the inflation in a country is increased.
Law of One Price
The concept of purchasing power has a basis in the law of one price. This implies that when additional costs for transaction and trade barriers are eliminated, similar products will go for the same price in different economies, when the cost is translated into the same currency. The law advocates for same price in diverse countries or markets where taxes and additional costs in transportation and management are removed.
When there are diversities between two markets, buyers may obtain goods from one market whose cost is less and sell in the other market. When the same product is sold elsewhere for less, buyers obtain the product where the price is low. The demand for products in the market that has low prices will be increased and the prices will be raised.
On the other hand, the supply of goods in the other market with high prices will increase and the price of the goods will be reduced. Integrated markets without additional taxes or costs will have matching prices for the commodity. When disparity arises, buyers will acquire the goods with low prices and resell them. Eventually, the prices will be equal hence; the law of one price will have been applied.
The law of One Price is challenged by trade barriers taxes, location differences, diverse trade laws and inadequate exchange of information. The price of the same commodity may be different in different markets within the same country. Consequently, the prices are likely to be different in other countries when the exchange rate is executed.
Economywatch (1) adds that for the Law of One Price to apply between two countries there should be an existing competition on the same commodity in each of the countries. The law concerns products that can be bought and sold in the countries in comparison. The law considers transportation, trade restrictions, applicable taxes and other additional costs as major hindrances.
The Law of One Price will apply to a single product while the Purchasing Power Parity applies to price level or a basket of goods. Assuming that the price level of one product will be similar to that of collective goods would be inappropriate. Different commodities vary in different markets. Purchasing Power Parity theory holds that equilibrium of the exchange rate between two currencies will result in an equal domestic purchasing power exchange rate.
The concept of Purchasing Power Parity is important since it makes it possible to compare the standards of living between different countries as Amadeo (1) points out.
When the cost of living is low, the amount required for production of goods for export is low. Hence, Purchasing Power Parity solves such issues. EconomyWatch (1) argues that products in different countries vary hence; using Purchasing Power Parity to determine the standards of living will be inappropriate. Purchasing Power Parity can be used to determine the rate of poverty in different countries.
There are two types of Purchasing Power Parity namely Absolute Purchasing Power Parity and Relative Purchasing Power Parity. Absolute Purchasing Power Parity focuses on maintaining equal prices for identical products in two countries.
Relative Purchasing Power Parity centers on increasing the currency rates after deriving disparity from the two countries trading similar products. Purchasing Power Parity is obtaining from price differences from two countries for identical products. The calculations are affected by diversity in preference for products and diversity in standard consumer products.
Obtaining measurements for Purchasing Power Parity can be challenging owing to the dispute of obtaining a suitable identical product for comparison between two countries. The products are referred to as a basket of goods. Prices in different industries such as housing, food, cloths, entertainment are diverse.
A favorable basket of goods can become difficult to obtain and relate with the unit index. The culture and perceptions of purchasing are also diverse in different countries. Some of the differences make companies configure the constituents and quality of the utilities to fit the unique needs of the specific customers. Comparing more than two countries is complicated if the diversity of adjusted goods and services to suit culture, quality and perceptions of different markets are to be considered (Deutsche 31).
Purchasing Power Parity measurements vary according to the methodology used to measure. Statistics recorded in different countries may vary hence; obtaining an accurate measurement will be challenging. Price structures in diverse countries vary. Some products are locally available, others are rare.
Comparing the products would be challenging because of location differences. Different formulas have been used and they offer different results. Linking regions can be of assistance in providing measurements. Similar items with similar costs in regions that are not dispersed can be considered to be reliable (Gardener 1).
Challenges in Purchasing Power Parity
The transaction value is obtained in the exchange rate of goods for domestic use and goods for export. Foreign exchange markets are also influenced by the purchase of capital assets, hedging, speculation, diversity in interest rate and intervention from central bank. Purchasing Power Parity has been used to correct statistical disparity. Countries GDP can be adjusted. In states whose governments control the foreign exchange market, the Purchasing Power Parity will be of benefit.
Domestic goods and services that are traded within the country like electric power are suitable for considering for the basket of goods. The goods that are long lasting like metal and diamonds and can trade in the global market and can be considered for Purchasing Power Parity comparison. Domesticated goods and services trade far from the exchange rates. Non perishable goods traded in the global markets trade closed to the exchange rate.
Government restrictions on trade and transport cost incurred when moving goods between markets are a stabling block. When the costs appreciate, the interest rates fluctuate. Customs fee and shipping fees are additional costs. When the additional cost is very high, the Purchasing Power Parity weakens.
The prices of non-tradable goods which are not linked internationally affect the Purchasing Power Parity. An example of non-tradable goods is the construction industry outcomes. The outcomes are impacted by deviations in supply and demand within the country. Consequently, the prices of goods and services are affected hence; some of the goods that are traded in the international market will be affected. The purchasing power will decrease if the cost of non-tradable goods and services are high.
Different market structures which cause diversity in the competition affect the Purchasing Power Parity. Segmented markets and differentiation of products have negative impacts. Unfair competition, trade barriers and control of national prices are common practices in the market. Diversity in demand causes a company to sell the same product at different prices in different countries. This situation can be reversed after a period when shifts in demand and change in market structure occur.
Price levels and consumption rates diverge in different countries. The level of inflation is varying just like the unit prices vary; hence exchange rates from the data may not reflect accurate measurement. The price change for every unit may differ largely and the level of inflation may not reflect actual fluctuation.
Purchasing Power Parity has been used to determine the international poverty line. The poverty line which reflects the national poverty line average is converted into international currency and then back to the currency against the Purchasing Power Parity exchange rates. The challenge is that the average costs for weights and prices that are used could be inaccurate. Those living below the poverty line may be using different price levels that differ with national prices.
The economic activities and structures in developing and developed countries are different. Grouping them together may introduce bias. Determining international living standards is equally challenging owing to the diversity in market structures and levels of development in different countries.
Monthly data on inflation rate
Inflation rate is the rise in the cost of commodities compared to the standardized purchasing power. Some of the measures of standards for inflation are the consumer price index (CPI) and the GDP deflator. They measure the inflation within the country. Below are the inflation rates in USA and Europe.
USA
According to Trading Economics (1), the inflation rate in the month of November this year was 3.4 percent. The average inflation for the last twelve months was 3.4 percent, a decrease compared to the average for the previous period of twelve months, which was 3.5 percent. In the last twelve months, the energy sector has declined from 14.2 to 12.4 percent.
Similarly, in the food sector, the index depreciated from 4.7 to 4.6. With the exception of food and energy sectors, the other sectors have experienced an average increase of 2.2 percent in November. Sectors that indicated a rise include personal care, shelter, apparel and medical care.
The monthly inflation rates in 2011 were as follows. In January 1.6 percent inflation was recorded. There was an increase in February where the inflation was 2.1 percent. An inflation of 2.7 percent was recorded in March and 3.2 percent in April. In May, June and July, the inflation stood at 3.6 percent every month. A rise was also experienced in September where the inflation was 3.8 percent and 3.9 percent in October. The inflation was at 3.4 in November 2011.
The inflation rate has been on the increase from the start of the year. The highest inflation was experienced in the month of September, with a high of 3.9 percent. In the past months, the inflation has been high. The inflation rate for the year 2011 is likely to be higher than the previous year. 2010. which had an inflation rate of 1.5 percent. In 2008, the annual inflation rate was at 0.1 percent, 2.7 percent in 2009 and 1.5 percent in 2010.
The month of November was characterized by unchanged prices for most of the price index for common goods. The credit has been given to the depreciating fuel costs (Deutsche 30).
Europe
The annual inflation rate was at 3.5 percent in 2008, 0.8 percent in 2009 and 1.8 percent in 2010. The European central Banks has a mechanism of maintaining the economy of the region by intervening in the inflation rate. When the inflation rate is high, the bank increases the interest rates and when the inflation is low, the interest rates are lowered.
The adjustments encourage investments and assist in correction of the growth rate. The bank aims at maintaining an inflation rate that is between 0-2 percent to encourage economic growth. Europe uses Consumer Price Indexes to determine the inflation rate. One of the uniqueness of the inflation rates in Europe is that the energy and food indexes are not used to determine Consumer Price Index (CPI).
According to the European Central Bank (62), the inflation rate in the last three months has been 3.0 percent. In August and July, the inflation stood at 2.5 percent while in June the inflation was 2.7 percent. The inflation rate has increased in the previous months and remains above the 2 percent mark that Europe targets to maintain.
EUR/USD data
In February, the EUR/USD traded at 1.3, then 1.4 in March and 1.42 in April, 1.5 in April. It traded between 1. 4 – 1.45 in March, June, July, August and September. It traded at 1.3 in September, 1.4 percent in November and 1.35 percent in early December.
USA and Europe uses Consumer Price Index in their quest to determine the inflation rate. However, Europe excludes energy and food prices when calculating the inflation rate and determining the price of a basket of goods. The argument is that energy and food prices are unpredictable and highly variable.
Fuel costs make food prices reduce and the purchasing power for both commodities to differ in the two countries. Although the European and USA markets are affected by global trends, how they react to the market challenges affects their rate of inflation and the price of goods and services.
Impacts of differences between USA and Europe inflation on the EUR/USD relations
The inflation rates have an impact on the economy of a country hence; the government and the central banks introduce policies that will safe guard economic interests. A number of major banks have been pursued to downgrade on long-term credits. This is in an attempt to reduce the rate of inflation. The measures affect the banks and lead to situations where they are at the verge of closing down. In similar circumstances, the interest rates increase when the inflation rate increases.
The central or national banks therefore intervene to implement policies. In USA, the economy had experienced economic turmoil and most banks were in bad shape. In 2008, the Federal Reserve was in the forefront to assist banks stay afloat in the harsh economic time. The banks responded to the inflation rates by tightening the requirements for lending loans.
In Europe, the central bank of Europe has been involved in the control of the market to manipulate the interest rates to remain low and encourage investment. The bank seeks to sustain an inflation rate of bellow 2 percent. The current inflation rate is above 3 percent and the government will implement policies that will encourage the inflation rate to be below 2 percent (European Central Bank: 12).
European countries have agreed to settle for a budget that allow minimum deficit. The challenge is the trends in the market, which are varying and unpredictable. Dominant trends tend to withstand the test of time and introduction of policies may become unfruitful. A large number of the European markets have an inflation rate that is lower than that of USA.
The low inflation rate in the majority of the European markets shows the ability of the European Central Bank to be effective with the intervention and the possibility of reducing current inflation rate of above 3 percent to below 2 percent. Continuous reduction in the inflation rate will encourage stability.
The USA inflation rates has remained high in the past months and reduced inflation by 0.1 percent in the last month of November. This is an indication that Federation Reserve is capable of bringing stability of the inflation rate as well as foreign exchange market rates.
Inflation rates affect the standards of living when there is an increase. The prices increase and the standards of living are lowered if the income is not increased. Planning for the future becomes challenging since prices keep increasing. Inflation can be managed by introducing policies and ensuring there is a balance between supply and demand.
Europe has been viewed as successful in the implementation of policies and has achieved a level of stability in some of the major markets. Countries that joined the European Union early have a low inflation rate than the new members of the union.
European Commission (1) points out that inflation weakens purchasing power and is harmful to businesses. To achieve Purchasing Power Parity, USA and Europe have adjusted their policies to enable economic growth. When the wealth of a country is increased, the consumers have increased income and can purchase the goods.
The challenge comes if the inflation rate is higher than that of other markets. The country with high prices of commodity will lose demand hence the policy makers in every country strive to maintain a low inflation rate like that of other markets to attain Purchasing Power Parity.
EUR/USD relations have been identified as positive. Policies that make Europe inflation rates depreciate affect the US dollar by decreasing its value. Federal Reserve intervenes in open market and when the intervention is successful, the EUR/USD decrease if the US dollar increases value. EUR/USD relations are strong. The dollar trades in a large number of markets and has been used in numerous transactions. The USA economy is one of the leading economies in the world.
The stability of exchange rates will maintain the Purchasing Power Parity. When there is a high inflation rate in one country than the other, the Purchasing Power Parity will differ. Then, policies and measures to stabilize the currency to enable Purchasing Power Parity will be adopted.
Conclusion
Purchasing Power Parity is defined as an approach for determining exchange rates of utilities linking different economies where the similar products should sell at identical prices in different markets. The cost of transport, shipping, applicable taxes and trade barriers are not included. Purchasing Power Parity is closely related to the Law of One Price. Law of One Price holds that a single product can be sold for the same price in two different countries where the cost of transport and other expenses are factored out.
The Law of One Price focuses on one product while Purchasing Power Parity focuses on a group of goods, which can be referred to as a basket of goods. The level of price is the main concern. The two types of Purchasing Power Parity are Absolute Purchasing Power Parity and Relative Purchasing Power Parity. They focus on the same prices for identical products in two countries and on mounting the currency rates after deriving inconsistency from the two countries trading similar products respectively.
Purchasing Power Parity is affected by variability in products, which is a challenge. The products demand and adjustment to suit the consumers may introduce bias in the measurement. Purchasing Power Parity affects exchange rates if acquisition of capital assets, hedging, speculation, diversity in interest rate and intervention from central bank are done.
Suitable goods for a basket of goods are domestic product and goods that are long lasting. Government restrictions on trade barriers and market structures can also affect Purchasing Power Parity. Inflation rates vary in different countries and will require adjustments. Purchasing rate has been used to gage the poverty levels and the standards of living.
The inflation rates of USA and Europe have been increasing, depending on economic dynamics. The EUR/USD relations are strong. Inflation in Europe will cause the EUR to be weak. The European Central Bank has introduced policies that will assist in strengthening the value of the currency. The USA Federal Reserve assists the open market economy to be sustainable and obtain a low inflation rate (Investopedia 1).
Works Cited
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Economy Watch. Purchasing Power Parity Theory of Exchange Rate, 2010. Web.
European Central Bank. Monthly Bulletin December, 2011. Web.
European Commission. The consequences of inflation, 2011. Web.
Gardener, Brian. US Inflation Calculator, 2011. Web.
Investopedia. Currency Pair: EUR/USD (Euro/U.S. Dollar), 2011. Web.
Suranovic, Steven. Introduction to Purchasing power parity (PPP), International Finance theory and Policy, 2009. Web.
Trading economics. United States Inflation Rate, 2011. Web.