Discuss PPP, its theoretical perspectives and empirical evidence

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In an international and globalize environment such as the national economies are growing in, it is hard to measure and evaluate the performances of each one in comparison with the others. Indeed, currencies are different all around the world and to what we can or cannot afford or in a foreign country with our national currency, we need to measure the purchasing power between a national currency and a foreign currency. Some economists have tried to build two principal tools to compare two economies performances. The first one takes in account and compares the nominal exchange rates on the exchange market between two different currencies. This method is the simplest one and gives an approximation of the real performances of two economies. Empirically, this method has shown a lot of limits and inaccurate results, which takes us to the second method. This one makes a comparison of the purchasing power that a home currency offers in a foreign currency. This tool is called the Purchasing Power Parity.

Extraits

[...] In accordance with this graph, we can see the comparison between several currencies and the US Dollar, and then the same currencies with the Canadian Dollar. currencies listed below are compared to the US Dollar. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the US Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the US Dollar in the long run. [...]

[...] Thus, that implies systematic divergences in the relative PPP. The general price level of domestic non-tradable goods raises the general price level in a country in comparison with the general price level in a foreign country. In other words, we can say that the purchasing power of a currency decreases in a country when the non-tradable goods price level rises. On the other hand, when an enterprise trades the same goods but at different prices in different markets, depending on the demand price- elasticity of each market, it makes the link between prices and exchange rates weaker. [...]

[...] Discussion What is the PPP? The theory of Purchasing Power Parity has been invented and developed in 1914 by the economist Karl Gustav Cassel (1866-1945) and follows the theory of Ricardo (1772-1823) based the analysis of the balance of payments of one country. The Cassel's theory is the generalization of the of one price” that says “that all portfolios with the same payoff have the same price”. That is: If h X = h' X Where h and h' are two portfolios and X their payoff, Then: Ph h = Pf h' where P is the price of the two portfolios. [...]

[...] Thus, predictions with the PPP methods regarding the evolution of prices and the purchasing power to another currency are still relevant in a long-term perspective thanks to the automatic long-term adjustments between markets. Bibliography Websites THE ECONOMIST WEBSITE, 1st February 2007, [Online], Available: http://www.economist.com/markets/indicators/displaystory.cfm?story_id= [Accessed 13 November 2007] COMMSEC WEBSITE January 2007, The CommSec iPod index [Online], Available: http://www.comsec.com.au/public/news.aspx?id=809, [Accessed 13 November 2007] OECD WEBSITE, no date, [Online], Available: http://www.oecd.org/department/0,3355,en_2649_34357_1_1_1_1_1,00.html, [Accessed 13 November 2007] PRICEWATERHOUSECOOPER REPORT PricewaterhouseCooper Website [Online], Available: http://www.pwc.com/cz/eng/about/press-rm/2006/pressrm05_06.html, [Accessed 15 November 2007] OECD Pacific FX Service PPP Reference, [Online], Vancouver, Available: http://fx.sauder.ubc.ca/PPP.html, [Accessed 15 November 2007] ANTWEILER, W The University of British Columbia website [Online], Vancouver, Available: http://fx.sauder.ubc.ca/PPP.html, [Accessed 15 November 2007] Books WANG, P., The Economics of Foreign Exchange and Global Finance September 2005, Kindle Edition LEROY, S.F., and WERNER, J., Principals of Financial Economics November 2000, Cambridge University Press BRIGHAM, E.F., EHRHARDT, M.C., Financial Management: Theory and Practice with Thomson ONE March 2004, Harcourt College Publishers Series in Finance BRESCIANI-TURRONI, C., The "purchasing power parity" doctrine Cairo SCHREYER, P., KOECHLIN, F., Cahiers statistiques de l'OCDE, Parités de pouvoir d'achat : mesure et utilisations Mars 2002, ROSS, S.A., WESTERFIELD, R.W. [...]

[...] The market mechanism, called by Adam Smith the “invisible hand of the market” in wealth of Nations” (1776), tends to raise the prices of a market where the demand is high. However this mechanism takes time, and the European and international level of price of goods can be different until the law of markets comes to rebalance this unbalance of exchange rate. The exchange rates volatility and the prices rigidity can help to explain this phenomenon. Therefore, in a short-term perspective, we can emphasize that these divergences are bigger when the exchange rates are changing fast. However, the facts show that these divergences are less obvious after one year. [...]