AMRUT MODY SCHOOL OF MANAGEMENT

H. L. INSTITUTE OF COMMERCE, AHMEDABAD

S. Y. B. COM. 2011-2012 DR. MITA H. SUTHAR Prof. Urvish Subodh

SYLLABUS: Concept of equilibrium exchange rate Absolute and relative versions of purchasing power parity theories of exchange rate determination. QUESTIONS: 1. Discuss critically the purchasing power parity theory of determination of foreign exchange rate. 2. What is foreign exchange rate? Why is there a need for foreign exchange rate? Explain the concept of equilibrium foreign exchange rate. INTRODUCTION: Interregional trade within a country is done using a single currency the one used in that particular economy. Only when two or more countries trade with one another, do we require the rate of conversion the rate at which one countrys currency will be converted / exchanged for another countrys currency. In other words, the exchange rate gives the price of one currency as expressed in terms of another. EQUILIBRIUM RATE OF EXCHANGE: Under gold standard, the mint par (based on the value of each countrys currency unit in terms of gold) can be regarded as the equilibrium rate of exchange. Under inconvertible paper currency standard, equilibrium rate of exchange is determined in several ways. Purchasing power parity theory is one of the ways to determine equilibrium exchange rate. However, in practice, exchange rate determination also takes into consideration other factors affecting the demand for and supply of foreign exchange. Robinsons version: The exchange rate obtained by equalizing the demand for and supply of foreign currency at a particular point of time and under certain conditions regarding the elasticities of demand for and supply of exports and imports and the balance of lending, can be called equilibrium exchange rate. However, in practice, it is difficult to measure such elasticities and hence, equilibrium exchange rate cannot be obtained easily. Nurkse definitions: 1. The equilibrium exchange rate is the one, which, over a certain period maintains the balance of payments in equilibrium without any net change in the international currency reserves. 2. Equilibrium exchange rate is the one that maintains the balance of payments in equilibrium without a degree of unemployment greater than that prevailing in the rest of the world. Such equilibrium can be obtained if the demand for each currency is equal to its supply, while there are no speculative or abnormal capital movements. Under such a balanced relationship between currencies of the various countries there is no over- or under- valuation of any currency, nor does it create any artificial trade advantages or disadvantages. Equilibrium exchange rate can be obtained only in the long run when the factors contributing to the emergence of seasonal fluctuations and trade cycles can be eliminated effectively, and the 1

rate can adjust itself so as to accommodate occasional fluctuations/changes in the balance of payments. Halms criteria for equilibrium exchange rate: 1. It should be compatible with an average degree of domestic stabilization. Any major changes in any of the macroeconomic variables in the economy (e.g., unemployment level) would give an exchange ratio, which is not equilibrium exchange rate. 2. Maintenance of equilibrium exchange rate should not be at the cost of the countrys reserves (which get exhausted) or by way of adoption of a deflationary policy (which causes unemployment in the economy) under adverse balance of payments conditions. 3. The exchange rate should not comprise of any competitive under-valuation, which would imply artificial advantages or disadvantages in the international trade. On the contrary, it must be totally neutral and reflect functional relations of price, cost and demand of various countries. LAW OF ONE PRICE (LOOP) Law of one price explains that the value of two goods in different countries should be same in relation to the exchange rate, LOOP only takes into consideration just one good or item. PURCHASING POWER PARITY THEORY: The purchasing power of the respective currencies can be used to determine foreign exchange rate under inconvertible paper currency standard. Richard Wheatley stated the purchasing power parity theory of foreign exchange rate determination in his work Remarks on Currency and Commerce in 1802. Gustav Cassel further developed it and christened it as the purchasing power parity theory in his work Money and Foreign Exchange After 1914 (1922). According to Cassel, the basic rate of exchange between two currencies is determined at the point where their respective purchasing powers are equal. The actual exchange rate at a particular point of time might be affected by fluctuations in the demand for and supply of foreign currency, although it tends to move towards the purchasing power parity based exchange rate. So Purchasing Power Parity holds when the Price (Value) of homogeneous or similar goods in two different countries would be same. For instance if the exchange rate is 45 INR/$ and if the value of an iPhone 4 in India 9000 rupees and the same phone in USA would cost 200 $, the condition of Purchasing Power Parity will hold, comparing PPP to LOOP, PPP can be for basket of goods and LOOP can only be considered for one item. Gold Standard Gold is considered to be one of the most liquid possible after cash and because it can be bought in number of currencies it might give a chance to find profitable opportunities which in reality does not exists due to high number of traders seeking the same. Looking at the rates on Yahoo! Finance on the 6th of August, 2011 (Closing previous day) following was found,

Gold (US) = 1663 $/ Ounce (1 Ounce = 28 grams, 1 Tola = 10 Grams) Exchange rate = 44.7250 INR/ $, Gold (IN) = 24025 INR/ Tola, Working out the exchange rate from the above information we get 40.45 INR/$, so now there is a difference between the actual exchange rate and the PPP exchange rate. So does this mean that PPP does not hold. Yes! It does not hold however taking into consideration number of transaction cost the value of the INR in $ would eventually come to the actual exchange rate or even more costly than the actual exchange rate, so it is possible it might hold if different transaction cost is taken into consideration. A. ABSOLUTE VERSION OF PRURCHASING POWER PARITY THEORY: The absolute version of the theory shows that exchange rate is determined at a particular time when the internal purchasing powers of the two currencies become equal. For instance, good(S) worth 1 in U.K. cost Rs.80 in India. Then, as per the absolute version of the PPP theory, the exchange rate between pound sterling and rupee is 1 = Rs.80. If the market rate of exchange is different from this PPP exchange rate, economic forces of demand and supply will bring it back to the PPP exchange rate level. For instance, if the exchange rate in the open market is 1 = Rs.90, it implies that purchasing power of pound sterling in terms of rupees has increased. This induces people in the UK to convert pound sterling into rupees and import goods from India, which is profitable for them. Consequently, demand for rupees in the UK will increase, while the supply of rupees will decline simultaneously. In the process, the value of rupee in terms of pound sterling appreciates till it reaches the PPP level of exchange rate: 1 = Rs.80. This process works in the opposite direction if the market rate of exchange moves to a value such as 1 = Rs.70. The assumption here is that prices of goods in both the countries are equal, which does not happen in reality. Since the internal purchasing power of the currency keeps on changing, the exchange rate keeps on changing as well. Simplifying the same we can say that Absolute Purchasing Power Parity is the theory of Law Of One Price applied to a Basket of Commodities, so assuming if the basket of commodity includes range of edible oil and butter the Absolute Purchasing Power Parity suggests that price (value) of the basket of currency in Home currency (INR) should be equal to the price (Value) in Foreign Currency($). So the exchange rate can be determined as follows,

So if the basket in India costs 450 INR and in US 10 $, the exchange rate would be 45 INR/$ and if the actual exchange rate is 45 INR/$ Absolute PPP would hold.

B. RELATIVE VERSION OF PURCHASING POWER PARITY THEORY: Explained by Cassel, the relative version of purchasing power parity theory of exchange rate indicates that changes in the domestic price level (Inflation) affect the exchange rate. While in the absolute version of the theory only one commodities were considered to determine the exchange rate, in the relative version internal purchasing power of the currency is considered with reference to a basket of

commodities. This implies that the equilibrium exchange rate and the changes therein depend upon the changes in the ratio of respective purchasing powers of the two currencies. Construction of exchange rate under relative version involves selection of some past exchange rate as the base equilibrium exchange rate. The changes in this exchange rate are measured by the ratio of price indices of the respective countries. Hence relative Purchasing Power parity suggests that if Inflation in UK is 2% and in India it is 9% and the exchange rate is 70 INR/GBP according to the Relative Purchasing Power Parity the Indian rupee should devalue or depreciate to offset the High inflation in India. So in equation form the relative PPP would look as under,

Combined example Absolute Purchasing Power Parity explains the use of Basket of currency and LOOP together and Relative Purchasing Power Parity uses Price Level (Inflation) and LOOP. So if the basket contains (Absolute) 2 items comparing its prices in two different countries will explain the PPP exchange rate. Now this exchange rate will change if there are changes in inflation i.e. the Price level. As both the theories Absolute PPP and Relative PPP come from PPP they will have similarities that both uses Law of One Price as their base theory, both theories have been explained internationally. Similarity

1. Now when Absolute PPP is calculated Weights are assigned according to consumer behaviour so comparing a basket that includes Butter and Oil the weights will be as under, US 7 3 India 3 7

Butter Oil

In USA the consumer behaviour is that they use more of butter compare to oil and hence with India the situation is the other way round. Now the similarity is that if the above example is taken into consideration it can be said that Relative PPP can be derived from the past price of the basket and then finding the Price Level (Inflation) out of that, with Absolute PPP the above example can be used. 2. Now taking the theory into consideration Relative as well as Absolute PPP uses Law Of One Price with is the similarity as both the theory comes from the Purchasing Power Parity theory which in turn has a base of Law of One Price, without Law of One Price the Theory cannot be taken into consideration. **Dissimilarities between Absolute and Relative PPP. Absolute Purchasing Power Parity Absolute PPP uses Basket of Items Absolute PPP suggests competitiveness Relative Purchasing Power Parity Relative PPP uses Inflation Relative PPP suggests Price Levels in 2 countries

3. The Absolute PPP uses Law of One Price in comparing the basket of Items ultimately comparing the Competitiveness of two countries. However Relative PPP explains Price Levels of two different countries via Law Of One Price. 4. Absolute PPP can have problems in case of change in consumer behavior i.e. the change in weights will change the value of the basket of Items, however change in consumer behavior will have an indirect effect of the same resulting into change in price levels.

CRITICAL EVALUATION OF THE PURCHASING POWER PARITY THEORY: 1. To compare the purchasing power of two countries currencies, changes in the price levels of the two countries must be measured, which requires construction of an appropriate price index. The first question here is: which price index should be considered wholesale price index or cost of living index? Wholesale price index ignores manufactured goods, services and other invisible exports; while cost of living index includes some commodities which do not have any bearing on international trade. Second, index numbers do not always provide an accurate picture of changes in the purchasing power of the currencies. Third, price levels of the two countries cannot be compared effectively since the consumption patterns are different in two countries. 2. The purchasing power parity theory compares general price levels in the two countries, which is not appropriate. Price level of domestic goods and price level of internationally traded goods are different, and only the latter affects demand for and supply of foreign currency, and therefore the exchange rate. Domestically traded commodities do not have any direct bearing on the exchange value of the currency, and fluctuations in the prices of these commodities will not affect the exchange rate. 3. A direct link between the purchasing power of the currencies and the exchange rate. However, in reality, the exchange rate is influenced by tariffs, quota regulations, speculation and capital movements in the concerned countries. For instance, imposition of tariffs by one country on its imports from the other country results in a decline in the imports, thus reducing the demand for foreign currency. Hence, the value of the tariff imposing countrys currency will increase although the internal price level in the country might not have changed at all. Highly erratic capital movements from one country to the other, and their speculative nature also cause fluctuations in the exchange rate. 4. The general price levels do not affect other components of balance of payments of a country such as shipping, banking, insurance, interest, capital movements, etc. However, these components do affect the exchange rate as they influence demand for and supply of foreign currencies, and they are ignored by the purchasing power parity theory. 5. Purchasing power parity theory does not take into account the effect of changes in the exchange rate on general price level. In reality, it has been found that exchange rates have become important determinants of the general price level in various countries. For instance, the exchange rate is affected by changing price level under the initial stages of inflation, but once inflation has gathered momentum, it is the exchange rate, which affects the price level.

6. The purchasing power parity theory fails to explain short run and day-to-day fluctuations in the exchange rate. 7. Even in the long run it is doubtful if the theory can explain the equilibrium exchange rate, since it is important to know the Base Exchange rate in order to calculate the new equilibrium rate. It is very difficult to know the original equilibrium exchange rate that prevailed between two countries. 8. Further, the new exchange rate would show the equilibrium exchange rate only with the assumption that the economic conditions have remained unchanged. This is unrealistic, since the economic conditions are constantly undergoing changes. For instance, purchasing power parity theory would not accommodate the changes in the equilibrium exchange rate due to the changing terms of trade between two countries. 9. When the basket of goods is assigned to the countries the items in the basket would be assigned weights so now is a basket has Butter and Oil in it, In India the basket would be weighted as 3:7 (Butter : Oil) so now in US it would be 7:3 due to number of reasons like consumer behavior and cost of the same, so now when there are changes in weights it would affect the presence of PPP. The above can be summed up into basic assumptions like Transaction costs, Government Intervention and Imperfect competition.

CONCLUSION: In spite of the limitations, purchasing power parity theory shows the correlation between price levels and equilibrium exchange rate between two currencies in the long run. It also shows that in the light of changing internal and external price levels, no country can go without adverse effects on her international trade unless subsequent and complementary changes are allowed in the equilibrium exchange rate. There are certain conditions when PPP would hold taking NAFTA (Appendix) as an example.

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Appendix
North American Free Trade Agreement (NAFTA)

On January 1, 1994, the North American Free Trade Agreement between the United States, Canada, and Mexico (NAFTA) entered into force. All remaining duties and quantitative restrictions were eliminated, as scheduled, on January 1, 2008. NAFTA created the world's largest free trade area, which now links 450 million people producing $17 trillion worth of goods and services. Trade between the United States and its NAFTA partners has soared since the agreement entered into force. U.S. goods and services trade with NAFTA totaled $1.6 trillion in 2009 (latest data available for goods and services trade combined). Exports totaled $397 billion. Imports totaled $438 billion. The U.S. goods and services trade deficit with NAFTA was $41 billion in 2009. The United States has $918 billion in total (two ways) goods trade with NAFTA countries (Canada and Mexico) during 2010. Goods exports totaled $412 billion; Goods imports totaled $506 billion. The U.S. goods trade deficit with NAFTA was $95 billion in 2010. Trade in services with NAFTA (exports and imports) totaled $99 billion in 2009 (latest data available for services trade). Services exports were $63.8 billion. Services imports were $35.5 billion. The U.S. services trade surplus with NAFTA was $28.3 billion in 2009. Exports The NAFTA countries (Canada and Mexico), were the top two purchasers of U.S. exports in 2010. (Canada $248.2 billion and Mexico $163.3 billion). U.S. goods exports to NAFTA in 2010 were $411.5 billion, up 23.4% ($78 billion) from 2009, and 149% from 1994 (the year prior to Uruguay Round) and up 190% from 1993 (the year prior to NAFTA). U.S. exports to NAFTA accounted for 32.2% of overall U.S. exports in 2010. The top export categories (2-digit HS) in 2010 were: Machinery ($63.3 billion), Vehicles (parts) ($56.7 billion), Electrical Machinery ($56.2 billion), Mineral Fuel and Oil ($26.7 billion), and Plastic ($22.6 billion). U.S. exports of agricultural products to NAFTA countries totaled $31.4 billion in 2010. Leading categories include: red meats, fresh/chilled/frozen ($2.7 billion), coarse grains ($2.2 million), fresh fruit ($1.9 billion), snack foods (excluding nuts) ($1.8 billion), and fresh vegetables ($1.7 billion). U.S. exports of private commercial services* (i.e., excluding military and government) to NAFTA were $63.8 billion in 2009 (latest data available), down 7% ($4.6 billion) from 2008, but up 125% since 1994.

Imports The NAFTA countries were the second and third largest suppliers of goods imports to the United States in 2010. (Canada $276.5 billon, and Mexico $229.7 billion). U.S. goods imports from NAFTA totaled $506.1 billion in 2010, up 25.6% ($103 billion), from 2009, and up 184% from 1994, and up 235% from 1993. U.S. imports from NAFTA accounted for 26.5% of overall U.S. imports in 2010. The five largest categories in 2010 were Mineral Fuel and Oil (crude oil) ($116.2 billion), Vehicles ($86.3 billion), Electrical Machinery ($61.8 billion), Machinery ($51.2 billion), and Precious Stones (gold) ($13.9). U.S. imports of agricultural products from NAFTA countries totaled $29.8 billion in 2010. Leading categories include: fresh vegetables ($4.6 billion), snack foods, (including chocolate) ($4.0 billion), fresh fruit (excluding bananas) ($2.4 billion), live animals ($2.0 billion), and red meats, fresh/chilled/frozen ($2.0 billion). U.S. imports of private commercial services* (i.e., excluding military and government) were $35.5 billion in 2009 (latest data available), down 11.2% ($4.5 billion) from 2008, but up 100% since 1994. Trade Balances The U.S. goods trade deficit with NAFTA was $94.6 billion in 2010, a 36.4% increase ($25 billion) over 2009. The U.S. goods trade deficit with NAFTA accounted for 26.8% of the overall U.S. goods trade deficit in 2010. The United States had a services trade surplus of $28.3 billion with NAFTA countries in 2009 (latest data available). Investment U.S. foreign direct investment (FDI) in NAFTA Countries (stock) was $357.7 billion in 2009 (latest data available), up 8.8% from 2008. U.S. direct investment in NAFTA Countries is in nonbank holding companies, and in the manufacturing, finance/insurance, and mining sectors. NAFTA Countries FDI in the United States (stock) was $237.2 billion in 2009 (latest data available), up 16.5% from 2008. NAFTA countries direct investment in the U.S. is in the manufacturing, finance/insurance, and banking sectors.

NOTE: Refers to private services trade not including military sales, direct defense expenditures, and other miscellaneous U.S. government services.