A Briefing of the Purchasing Power Parity (PPP)

PURCHASING POWER PARITY

During the last decades, The Purchasing Power Parity, shortly – PPP, has been a controversy among economists regarding its validity. The exchange of the purchasing power takes place at a certain exchange rate where the purchasing powers of domestic and foreign currencies are equal. To emphasize its importance, this essay builds up a deepen analysis of the purchasing power parity theory and discuss the extent to which financial managers should or should not devote time and attention to the concept.

PPP concept and the Law of One Price

According to Suranovic (1997), ‘’Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries’’. Another interpretation of the theory is given by Darby (1983) as follows: ‘’Purchasing power parity is a customary starting point for explanations of price changes in a country maintaining a pegged exchange rate with a reserve country whose price changes are taken as given’’. Shortly, the PPP theory states that exchange rates between currencies are in equilibrium when they have the same purchasing power in each of the two countries involved. What this means is that for example, taking the exchange rate into account, a bundle of goods should have the same price in the UK and France when expressed in the same currency.

The Purchasing Power Parity, also called the ‘’Inflation Theory of exchange rates’’, is based on an overall price index that builds up a common base for country comparisons by connecting the currencies of different countries to a mutual unit. In this case, PPP is superimposed as an a priori condition to convert a country’s income and expenditure in local currency t...

... middle of paper ...

... goods should be the same.

The Law of One Price forms the basis of the PPP theory presenting its own limitations within the modern business world.

After carefully analyzing the purchasing power parity theory, the extent to which financial managers should or should not devote time to the concept has been discussed concluding that despite criticism, PPP is still a theory that needs to be considered in order to reduce the foreign exchange risk.

BIBLIOGRAPHY

Robert J. Hodrick Geert Bekaert, 2013. International Financial Management. International ed of 2nd revised ed Edition. Pearson Education Limited.

Japan Consumer Price Index (CPI) | Actual Data | Forecasts | Calendar . 2014. Japan Consumer Price Index (CPI) | Actual Data | Forecasts | Calendar . [ONLINE] Available at: http://www.tradingeconomics.com/japan/consumer-price-index-cpi. [Accessed 01 May 2014].