Explanation of purchasing power parity
The theory of purchasing power parity is based on the premise that the price of identical goods in different markets or countries has the same value, when it is expressed in terms of a single currency (Brigham & Houston 2008, p 574; Crinkova et al 2008, p 178).
Moreover, this theory implies that the exchange rate of different currencies has to be equal to the ratio of price levels in two countries. It is necessary to elaborate this argument by providing some examples. For instance, the price of a product is 2 dollars, while the same product costs 10 yens in Japan. Hence, the exchange rate of dollar to yet should be 1 to 5. Overall the notion of purchasing power parity can explained with the help of this equation:
Spot Rate = P1/P2
In this case, P1 and P2 are prices of the same product in two countries. The theory of PPP implies the exchange rate of currencies is going to change when the prices either increase or decrease. It should be noted that the concept of PPP is possible only if there are no transaction costs. In the next section we will explain why the empirical tests indicate at deviations from this model.
Deviations from purchasing power parity
There are several reasons why there are numerous deviation from this law. First, it relies on the premise that there are no trade barriers or transportation costs, which are certainly reflected in the price of a product (Tuckman, 2002, p 10). Hence, the goods may cost 100 dollars in the United States, however, after transportation their price may increase to 115 dollars.
The second reason is that the exchange rate is also influenced by the demand for a certain currency, and it is not directly connected with the cost of goods in the country. Thirdly, the cost of product is dependent on the government regulations, for instance, the cost of cigarettes is higher in the European Union than in Eastern Europe; however, it can be explained by the fact that the governments of EU countries attempt to reduce nicotine consumption.
Hence, one can argue that government interference into economy can be a factor that disrupts purchasing power parity. The fourth reason is that the price of a product is directly proportionate to its availability on the market. Again we need to refer to specific example. The production volumes of cars in Germany can be much higher than that one in Spain.
Therefore, higher level of supply can eventually diminish the price of product. These are the main reason which explains why the theory of purchasing power parity is not always substantiated by empirical tests and why it is not applicable to the exchange rate. Overall, it is possible to say that this model overlooks some essential market forces such as intensity of competition, the bargaining power of customers, the availability of substitute products, etc.
Each of these dependent variables affects the prices of goods and services and they are different across countries. Furthermore, it does not take into account the fact that the exchange rate of a currency depends on economic performance of the country, political situation in a certain region. This model is possible only in a hypothetical market, in which there are no import quotas, transportation costs, and government’s interference in business.
Brigham E. & Houston. J. (2008) Fundamentals of financial management.. NY: Cengage Learning
Gomez. E. (2008) Financial Markets Institutions And Financial Services.London: Prentice Hall.
Crinkova M. Ronkainen I & Moffett M. (2008) Moffett M. Fundamentals of International Business. Wessex: Wessex Publishing.
Tuckman B. (2002). Fixed income securities: tools for today’s markets. NY: John Wiley and Sons.