Purchasing Power Parity, Research Paper Example

Purchasing Power Parity is a theory that implies to an important financial concept that is applicable in the process of estimation of potential adjustments of the exchange rates amongst states so as to harmonize the exchange to the purchasing power of their currency. The Big Mac Index is applied in atypical manner for the determination of Purchasing power parity of two states. It serves the role of simplifying the exchange rate mechanism which appears to be complicated (Taylor, 1995).

So many changes are encountered as an individual moves from one corner of the planet to the other but appropriate measures of currency conversion have been put in place by the economists. Consequently, the value of similar products available in diverse nations is expected to be similar after the exchange rate of the two nations has been adjusted (Taylor & Peel, 2000).

Purchasing Power Parity is a relationship that has undergone an extensive analysis in global monetary literature. The simplest way to calculate purchasing power parity between two countries is to compare the price of a “standard” good that is in fact identical across countries. The relative version of PPP is calculated as:

S = (P1/P2)

Where: ‘S’ stands for currency 1 exchange rate relative to currency 2

‘P1’ stands for cost of a product “x” in currency 1

‘P2’ stands for cost of a product “x” in currency 2 (Taylor & Peel, 2000).

The theory of Purchasing power parity is an important tool that facilitates for a comprehensive understanding of the exchange rate differentials. It is however imperative to note that exchange rates do not always converge in the long run as predicted by PPP. Purchasing power parity has been an interesting issue to the economists and has been applied as a very beneficial building block of macroeconomics models in numerous open economies. However, it has been associated with significant complexities in its empirical establishment.

Importance Of PPP In Managing Risks

One of the primary uses of PPP is in reducing the misleading effects of shifts in a national currency. This comes into play when calculating the nation’s Gross Domestic Product (GDP). For example, if a good in a particular country falls in value to 80% of its original value on the dollar, the GDP will also drop 80% as expressed in US dollars. This phenomenon does not reflect the standard of living in that country, a common use of GDP (Cuddington, & Liang, 2000).

According to purchasing power parity, the price for any one good should be equal across markets. This therefore means that the price for any combination or basket of goods should be equalized. This theory however does not always work in practice. In fact, anything which limits the free trade of goods will limit the opportunities people have in taking advantage of the profits resulting from the disparity in the prices of the particular goods in any two given countries (Fleissig & Strauss, 2000). A few of the larger limits are:

Import and Export Restrictions

Restrictions such as quotas, tariffs and laws make it difficult to buy goods in one market and sell them in another.

Travel costs

If it is very expensive to transport goods from one market to another there will be a difference in prices in the two markets.

Perishable goods

It may be impossible to transfer perishable goods from one market to another.

Location

This is a significant limit considering that it might be impossible to buy a piece of property in one state and move it into another. This results in real-estate prices varying wildly. Since the price of land may not be the same everywhere, it will impact on prices, as retailers in one state may have higher expenses than retailers in the other state.

Exchange risk refers to a simple concept of gain or losses that are incurred due to the changes in exchange rates. The effects of a risk are minimized if it can be anticipated which is evident in some currencies whose contracts of forward exchange indicate the direction of the currencies in the market. The contracts are the basis of the ability of locking anticipated changes and the anticipated changes in the exchange rates gives the idea of managing exchange risk (Cuddington & Liang, 2000).

The rates of exchange, rates of inflation and the interest rates have a common link through some classical relationships which in turn have considerable impact on risks allied tied to corporate foreign exchange, the relationships include the theory of PPP, international fisher effect and the theory of unbiased forward rate (Fleissig & Strauss, 2000).

Research Method

This section spells out the procedures and the methods that the researcher employed in achieving the objectives of the project so highlighted in the abstract of this paper. The research starts with the clear understanding of the research objectives that are intended to be achieved in this paper. Success of the project is a factor of the provision of satisfying information in line with the in the determination of the contribution of purchasing power parity in managing risks (Fleissig & Strauss, 2000).

Research Procedure

This research has adopted the option of secondary specifically dealing with the collection and use of existing data. The main advantage of secondary research is that it is not as time consuming as primary research (Cuddington & Liang, 2000).  However, information obtained through secondary sources may not be accurate as to meet the objectives of a particular research study. Regarding the current research study, the main sources of secondary data are;

1. Previous researches papers on the subjects
2. Relevant journals and books especially those touching on purchasing power parity and Global Financing and Exchange Rate Mechanisms
3. Relevant internet sources
4. Other related sociology materials as the researcher finds appropriate to use.

Validity and Reliability of Results

A debate about the findings of the preceding literatures inevitably includes a discussion of ‘research’, normally referring to the way in which the collection and use of existing data is achieved. This research being a phenomenological one will have all data collected being related to theoretical characteristics discussed in the literature review. The process will therefore be expected to be accurate in collecting the data and as such, the validity of the research would be quite high notwithstanding the fact that there are many different aspects of validity which influence the validity of a research in general.

Limitations Of The Research

Limitations are usually present in every research and these limitations actually tarnish the results of the research. Certain limitations are also associated with this research. Certain chunks or sources of secondary research are treated as a limitation of the research. This is because of the fact that these sources are not valid or they are not updated therefore the data that is attained from these sources might affect the entire results of the research. Therefore, the researcher should take utmost care about all these constraints and try to minimize it

References

Cuddington, J., & Liang, H., (2000). “Purchasing power parity over two centuries?” Journalof International Money &Finance 19 (5), 753e757.

Fleissig, R., & Strauss, J., (2000). “Panel unit root tests of purchasing power parity for price indices”. Journal of International Money & Finance 19 (4), 489e506.

Taylor, P., (1995). “The Economics of Exchange Rates”. Journal of Economic Literature, 33, 13-47.

Taylor, P., & Peel, A., (2000). “Nonlinear adjustment, long-ran equilibrium & exchange rate      fundamentals”. Journal of International Money & Finance 19 (1), 33e53.