Purchasing power parity (PPP) with transaction costs. Focus on the role of the transaction costs in explaining the exchange rate under the PPP theory comparing the articles in which the transaction costs are not taken into account. Essay Example
7Purchasing Power Parity & Transaction Cost
Purchasing power Parity (PPP) is an economic theory that explains that exchange rates linking two or more currencies are believed to be in equilibrium when the purchasing power of these currencies is similar in their respective countries. This implies that exchange rate involving for instance two countries should be same to the relative amount of the two countries’ relative cost levels (Abuaf & Jorion, 2010). In case the price level of a particular nation rises, meaning the nation experiences inflation, in order to sustain the purchasing power parity, its currency ought to be depreciated.
PPP theory is formulated into two accounts by economic scholars, which are absolute and relative PPP. Absolute purchasing power parity entails to the equalization of actual price levels across nations. Relative purchasing power parity entails that the proportionate change in exchange rates, within a given period is equivalent to the difference in proportionate change in price of different nations (Cheung & Lai, 2010). The purchasing power parity exchange rate is also known as the real exchange rate. The real exchange rate variations are more often than not as a result of diverse rates of inflation within two countries.
Purchasing power parity and exchange rate
The concept of PPP is based on long-standing equilibrium exchange rates founded on comparative price levels between two nations.Apart from this unpredictability, constant variations of the market and the real exchange rates are monitored, for instance the exchange rate at the market for the cost of non-traded products are typically lower wherever incomes are lower (Bayoumi & MacDonald, 2009). A sterling pound exchanged and used in China will pay money for a gadget than a pound used in the United Kingdom. In essence, PPP presumes exchange rates within two currencies by locating products available to buy in either of the currencies and contrasting the total value of those products in every currency.
There can be blotted disparities linking purchasing power parity and marketplace exchange rates. For instance, the World Bank’s pointers in the year 2005 approximated that in the year 2003, an international dollar was comparable to almost 1.8 Chinese Yuan by PPP, which was significantly differently from nominal exchange rate. The inconsistency has huge inferences, for example the Gross Domestic product per capita within china is almost US$1200 whereas on a purchasing power parity source it is almost US$3100.This is commonly employed to affirm that china is the second largest economy, but such approximation will simply be applicable under the PPP theory, at nominal exchange rates in its financial system is no more than the fifth largest (Lothian & Taylor, 2007). At another illustration of heightened instance is Denmark’s nominal Gross Domestic Product per capita is approximately US$62,100, although its purchasing power parity is simply US$37,400.
Role of transaction costs in explaining exchange rate under PPP
The transaction costs is perceived to drive a wedge between the relative price and the exchange rate, ruling out the verdict of long-run purchasing power parity if such costs do trail a fixed procedure. In any marketplace where same goods are sold at different places, it’s expected to see same price tag. Similarly, the price for these products will remain the same across borders when the currency is converted. The propensity of selling same products for same prices offers a connection between prices and exchange rates. One reason why there is variation in exchange rates is perhaps the variation of product prices within a given period both locally, regionally and internationally hence change in exchange rates must change to maintain the calculated prices in a common currency equivalent across nations.
According to Lothian and Taylor (2007), transaction costs play a great role in determining the price of goods in one basket under the PPP concept. Given the fact that price is expressed in single currency where sellers make riskless proceeds through shipping products from places where prices are low to places where prices are high (for instance through arbitraging). In case similar goods cross over to another nation which participated in the creation of aggregate price level under same weight of transaction costs, then the law of one price means that a purchasing power parity exchange rate will hold between the nations concerned.
The PPP operates on assumption that there are no transaction costs, but in real sense the transaction costs exist and its effect will in most cases cause a band in the deviation from purchasing power parity, which is a real exchange rate, and may vary without even a site into global movement of arbitrage of goods. This is for the reason that in the presence of transaction costs, the arbitrage activity rarely take place for those commodities under which profits from arbitrage is much lower compared to the transaction cost.
Reason why transaction costs are not taken into account at PPP
Each country has its own tastes and consumption behavior; hence the use of price indexes to weigh against the price level between two nations over a specified period may not be suitable as each nation’s price indexes will potentially comprise in some way different goods in the index. As a result, prices may not behave in the same manner within two nations.
It is believed that in ideal world where there is no transaction costs, transportation and logistics costs, and assuming all the products are traded globally, then law of one price holds for every product separately (Lothian & Taylor, 2007). Sometimes transaction costs are not taken into account at PPP especially because they are believed to be not enough to cause a considerable band of inaction in the deviation in the PPP hence not arbitrage away from the market forces.
The concept of PPP is founded on the logic of the law of one price, hence in absence of transaction costs (i.e. transportation costs and change in tax) the commodities should cost similar price in another country. This is for the reason that in a free market economy, individuals always make use of price differentials (Artus, 2006). For instance, if exchange rate is primarily put into consideration, the Home Theatres are found to be cheaper in Canada, US traders may buy them in Canada and sell at a profit margin in the United States. As a result, this will raise their demand in Canada till the price increase to meet that charged in the United States.
The thought that PPP would hold for the reason that global commodities arbitrage is correlated to the professed “law of one price” which emphasizes that price of a global traded commodity must be similar anywhere in the world once that price is articulated in a common currency, because traders may ship the commodities from one location where they are cheap to location where the price is high to make profits.
In real life situation, the PPP is particularly uncommon given the fact that there are frequently enormous price variations between different markets in same nation, let alone between diverse nations with different exchange rates. The PPP theory believes that this variations is as a result of varying transaction costs (sales taxation) existing between different nations. Also, because of logistics costs between countries and trade barriers like import duties and tariffs (Lothian & Taylor, 2007). Some economic scholars affirm that the variations may also be caused by varying patterns in the market forces.
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