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4
PURCHASING POWER PARITY
CONTENTS
4.0 4.1 4.2 Aims and Objectives Introduction Purchasing Power Parity (PPP) 4.2.1 Absolute Purchasing Power Parity 4.2.2 Relative Purchasing Power Parity 4.2.3 Graphic Analysis of PPP 4.2.4 Empirical Testing of PPP Theory 4.3 Interest Rate Parity Theorems 4.3.1 Graphic Analysis of the International Fisher 4.3.2 Comparison of PPP, IFE and IRP Theories 4.4 4.5 4.6 4.7 4.8 Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings
4.1 INTRODUCTION
The two theories discussed in this lesson are the Purchasing Power Parity (PPP) theory and the International Fisher Effect (IFE). If the PPP and IFE theories hold consistently, decision-making by MNCs would be much easier. Because these theories do not hold consistently, an MNCs decision-making becomes very challenging. The lesson also discusses the several key international parity relationships such as IRP and PPP that have profound implications for international financial management. The
relationship between inflation and exchange rates according to the PPP theory is discussed first. The graphic analysis, along with the empirical testing of PPP, is discussed. The PPP theory is discussed thoroughly as this is one of the most important and popular areas in international finance. The lesson then discusses the IFE. The IFE suggests that the exchange rate adjusts to cover the interest rate differential between two countries. This theory suggests that in efficient markets, with rational expectations, the forward rate is an unbiased forecast of the future spot rate. Finally, the lesson presents a comparison of the three theories PPP, IFE and IRP. The phenomenon of exchange rates movement is an important issue in international finance and managers of multinational firms, international investors, importers and exporters and government officials attach enormous importance to it. In fact, they have to deal with the issue of exchange rates every day. Yet, the determination of exchange rates remains something of a mystery. Forecasters with the most impressive records frequently go wrong in their calculations by substantial margins. However, many times poor forecasting is due to unforeseeable events. For example, at the beginning of 1984, all forecasters uniformly predicted that the dollar would decline against other major currencies. But the dollar proceeded to rise throughout the year although in other respects the general performance of the world economy did not radically depart from forecasts. This clearly shows that the theoretical models or other models used by forecasters were not correct and also that the mechanics of exchange rate determination needs to be studied thoroughly. The tremendous increase in international mobility of capital as a result of marked improvements in telecommunications all over and also lesser restrictions on international financial transactions has made the concept of exchange rate determination more complicated and difficult to understand. The above factors have often resulted in the forex market behaving like a volatile stock market. In fact, economists now have been forced to reverse their thinking about exchange rate determination. Thus, while much remains to be learned about exchange rates, a lot is also understood about them. Exchange rates forecasts have often been wrong, though many times they have also met with impressive success. Also, when exchange rate determination has been matched against historical records, it has had much explanatory power. Are changes in exchange rates predictable? How does inflation affect exchange rates? How are interest rate related to exchange rates? What is the proper exchange rate in theory? For an answer to these fundamental issues, it is essential to understand the different theories of exchange rate determination. The three theories of exchange rate determination are: 1. 2. 3. Purchasing Power Parity (PPP), which links spot exchange rates to nations price levels. The Interest Rate Parity (IRP), which links spot exchange rates, forward exchange rates and nominal interest rates. The International Fisher Effect (IFE) which links exchange rates to nations nominal interest rate levels.
Specifically, if subscript 0 refers to the base period and 1 to a subsequent period then relative PPP theory postulates that
Rab 0 =
where Rab1 and Rab0 refer to the exchange rates in period 1 and in the base period respectively. If the absolute PPP were to hold true, the relative PPP would also hold. However, the vice versa need not hold. For example, obstructions to the free flow of international trade like transportation costs, existence of capital flows, government intervention policies, etc. would lead to the rejection of the absolute PPP. However, only a change in these factors would lead to the rejection of the relative PPP. Other problems with the relative PPP theory are: first, ratio of prices of non-traded goods to the prices of traded goods and services is consistently higher in developed nations than in developing nations, e.g., the services of beauticians, hairstylists, etc., are more costly in developed nations than in developing nations. This is partly due to the fact that in developed nations, for labour to remain in these occupations, it must receive wages somewhat comparable to the high wages in the production of traded goods and services. The result is that prices of non-traded goods and services is much higher in developed than in developing countries. Second, the general price level index includes the prices of both traded and non-traded goods and services and the prices of non-traded goods are not equalised by international trade but are relatively higher in developed nations. The result of the above is that the relative PPP theory will tend to undervalue exchange rates for developed nations and overvalue exchange rates for developing nations with distortions being greater the greater the differences in the levels of development. Finally, since various factors other than relative price levels can influence exchange rates in the short run, it can hardly be expected that the relative PPP will result in an accurate forecast. In spite of the above deficiencies, empirical tests have indicated that the relative PPP theory often gives fairly good approximations of the equilibrium exchange rate, particularly in periods of high inflation. Second, the PPP holds well over the very long run but poorly for shorter time periods.
Exhibit 4.1
Ih-If (%) PPP line
-4
-2 -2
-4
Point B in the diagram shows a point where the difference in the inflation rates in India and Mexico is assumed to be 3% so that Ih-If = -3%. This will lead to an anticipated depreciation of the Mexican peso by 3 per cent, as depicted by point B. If the exchange rate responds to inflation differentials according to the PPP, the points will lie on or close to the PPP line.
2.
3.
4.
disadvantage regarding the foreign interest rate. But the IFE theory suggests that the currency should appreciate by 3 per cent to offset the interest rate disadvantage. Also, the IFE suggests that if a company regularly makes foreign investments to take advantage of higher foreign interest rates, it will achieve a yield that is sometimes below and sometimes above the domestic yield. Points above the IFE line like E and F reflect lower returns from foreign deposits than the returns that are possible domestically. For example, point E represents a foreign interest rate that is 3 per cent above the home interest rate. Yet, point E suggests that the exchange rate of the foreign currency depreciated by 5 per cent to more than offset its interest rate disadvantage.
Exhibit 4.2: Illustration of IFE Line (When exchange rate changes perfectly offset interest rate differentials)
Ih-If (%) 5
IFE line
3 F 1
-5
-3
-1
-1
E A
-3 y -5
Points below the IFE line show that the firm earns higher returns from investing in foreign deposits. For example, consider point Y in the diagram. The foreign interest rate exceeds the home interest rate by 4 per cent. The foreign currency also appreciated by 2 per cent. The combination of the higher foreign interest rate plus the appreciation of the foreign currency will cause the foreign yield to be higher than what was possible domestically. If an investor were to compile and plot the actual data and if a majority of the points were to fall below the IFE, this would suggest that the investors of the home country could have consistently increased their investment returns by investing in foreign bank deposits. Such results refute the IFE theory.
accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differential.
Table 4.1: Comparison of IRP, PPP and IFE Theories
Theory Interest Rate Parity (IRP) Key Variables of Theory Forward rate premium (or discount) Interest differential Summary of Theory The forward rate of one currency with respect to another will contain a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return. The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between the two countries. Consequently, the purchasing power for consumers when purchasing goods in their own country will be similar to their purchasing power when importing goods from the foreign country. The spot rate of one currency with respect to another will change in accordance with the differential in interest rates between the two countries. Consequently, the return on uncovered foreign money market securities will, on an average, be no higher than the return on domestic money market securities from the perspective of investors in the home country.
Check Your Progress 2 State whether the following statements are True or False: 1. 2. 3. 4. 5. The PPP theory focuses on the inflation exchange rate relationship. The IFE uses inflation rate rather than interest rates to explain the changes in exchange rates over time. A countrys nominal interest rate is usually defined as the risk free interest rate paid on a virtually costless loan. The relative PPP theory often gives fairly good approximations of the equilibrium exchange rate, particularly in periods of high inflation. Purchasing power parity links spot exchange rates to nations price levels.
4.6 KEYWORDS
Purchasing Power Parity (PPP): It links spot exchange rates to nations price levels. Interest Rate Parity (IRP): It links spot exchange rates, forward exchange rates and nominal interest rates. International Fisher Effect (IFE): It links exchange rates to nations nominal interest rate levels. Relative Purchasing Power Parity: The relative form of PPP theory is an alternative version which postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period. International Fisher Effect: The International Fisher Effect (IFE) uses interest rates rather than inflation rate differential to explain the changes in exchange rates over time.