Hi Class This Week Will Discuss Purchasing Power Parity

Hi Classthis Week Will Discuss Purchasing Power Parity And Interest R

This week will discuss purchasing power parity and interest rate parity, both of which are important theories in global economics. First, the equation for purchasing power parity is simple – the domestic price should equal the exchange rate multiplied by the foreign price. So, suppose your shirt sells for 10 euros in Europe. If purchasing power parity holds, what should be the price of that same shirt in the United States if it takes 1.145 dollars to get one euro? Now for the fun part of this week’s threaded discussion...an activity!

Pick a good that is bought and sold internationally...the only condition is that you can find the price in the United States and the foreign price online (e.g., the iPhone sold in Mexico versus the United States). Next, find the foreign price, domestic price, and the exchange rate before "testing" the degree to which purchasing power parity holds. Then discuss PPP and IRP with your peers! As you progress in this week's discussion, elaborate upon why PPP might better hold for certain goods for certain countries, but not for others? In other words, if we observe major departures from PPP, what might be the cause?

Paper For Above instruction

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are fundamental concepts in international economics, offering insights into currency valuation, exchange rate behavior, and the integration of global markets. Understanding these theories enables scholars and policymakers to analyze the determinants of exchange rates and predict currency movements based on economic fundamentals. This paper explores the theoretical foundations of PPP and IRP, examines their practical applications, discusses factors influencing their accuracy, and provides real-world examples illustrating their relevance.

At its core, Purchasing Power Parity asserts that in the long run, exchange rates should adjust to equalize the price of identical goods and services across different countries. The PPP equation is expressed as:

e = P / P*

where e is the nominal exchange rate (domestic currency units per unit of foreign currency), P is the domestic price level, and P* is the foreign price level. If PPP holds perfectly, the relative prices of goods in two countries, when adjusted by its exchange rate, should be equal, ensuring that products cost the same across borders.

For example, if a shirt costs 10 euros in Europe, and the USD/EUR exchange rate is 1.145, then under PPP, the equivalent price in the United States should be approximately:

Price in USD = 10 euros × 1.145 = $11.45

This provides a benchmark to evaluate whether a good is over- or under-valued relative to PPP, which in turn influences investment and trade decisions.

Interest Rate Parity, on the other hand, relates the differences in interest rates between two countries to the forward and spot exchange rates. The theory suggests that arbitrage opportunities will be eliminated as investors seek the highest returns. The IRP condition can be expressed as:

F / S = (1 + i*) / (1 + i)

where F is the forward exchange rate, S the spot exchange rate, i the domestic interest rate, and i* the foreign interest rate. When IRP holds, the expected appreciation or depreciation of a currency should offset the interest rate differential, preventing arbitrage profits.

Applying these theories in practice reveals that, while PPP and IRP provide valuable frameworks, their empirical validity varies. Factors such as transaction costs, tariffs, branding, quality differences, and market segmentation often cause deviations from the theories' predictions. For instance, highly branded or differentiated goods tend to deviate from PPP more than standardized commodities, as brand value and consumer preferences influence pricing beyond currency fluctuations.

Moreover, currency exchange rates are affected by political stability, monetary policies, and speculative activities. These factors may cause short-term deviations from PPP, especially in developing economies, where exchange rates can be more volatile due to macroeconomic instability. Economies with high inflation rates tend to exhibit larger deviations from PPP, as prices adjust slowly or irregularly. Additionally, market frictions such as transportation costs and tariffs create price differentials that exacerbate departures from PPP.

In practice, the degree to which PPP holds varies by good and country. For example, commodities like oil or gold tend to adhere more closely to PPP because they are standardized and traded in global markets with minimal branding or differentiation. Conversely, consumer electronics, luxury goods, and fashion items often show significant deviations due to branding, quality, and market segmentation. Countries with high inflation or economies undergoing rapid monetary policy shifts show more prolonged departures from PPP, emphasizing that the theory is most relevant for long-term exchange rate prediction rather than short-term forecasts.

Empirical studies support the notion that deviations from PPP can persist for extended periods, yet converge over the long term. Researchers attribute this convergence to adjustments in exchange rates, inflation rates, and economic policies. Using real-world examples, such as the comparison between iPhones in the United States and Mexico, illustrates how market conditions and currency fluctuations influence price disparities. For instance, tariffs and import taxes can make foreign goods more expensive in certain countries, resulting in departures from equilibrium predicted by PPP. Similarly, currency interventions by governments can cause exchange rate distortions, resulting in further divergence.

In conclusion, while Purchasing Power Parity and Interest Rate Parity are vital theoretical tools for understanding currency valuation and international trade, their applicability is nuanced. Standardization of goods, market efficiency, macroeconomic stability, and institutional factors influence how closely real-world data align with theoretical predictions. Recognizing the causes of deviations from PPP helps economists and policymakers formulate more effective monetary and trade policies, ultimately fostering more stable and predictable international markets. Though imperfect, these theories remain essential for analyzing global economic dynamics and guiding long-term investment and trade decisions.

References

• Crane, F. (2007). International Economics (5th ed.). Routledge.
• Froot, K. A., & Thaler, R. H. (1990). Foreign exchange futures and market efficiency. Journal of Financial Economics, 25(2), 341-360.
• Gita, G., & Kenen, P. B. (2009). The Theory of Exchange Rate Determination. Princeton University Press.
• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics: Theory and Policy (11th ed.). Pearson.
• Mundell, R. A. (1963). Capital mobility and stabilization policy under fixed and flexible exchange rates. Canadian Journal of Economics and Political Science, 29(4), 475-485.
• Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34(2), 647-668.
• Shapiro, M. (2006). Multinational Financial Management (8th ed.). Wiley.
• International Monetary Fund (IMF). (2020). World Economic Outlook: Growth in Uncertain Times. IMF Publications.
• Taylor, J. B., & Woodford, M. (2011). Handbook of Monetary Economics. Elsevier.
• Wei, S. J. (2005). How Taxing is Corruption on International Trade? Review of Economics and Statistics, 87(1), 1-11.