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Table of Contents
Problems and Issues Associated with Purchasing Power Parity.
The Concept of PPP
In accordance with Deaton and Dupriez (2011), the concept of purchasing power parity is related to the adjustments that are required to be made within the exchange rate of the currencies of two different countries to bring them at the similar level of purchasing power of one another. The main aim of PPP is the comparison of the income levels in different countries, which makes it convenient to study and comprehend the main economic information about each country. (Meyskens, Robb‐Post, Stamp, Carsrud and Reynolds, 2010). In the view of Prodan (2012); however, one of the major criticism of the theory is that it stresses upon the direct relationship between the purchasing capacity of the currencies of two economies; whereas, practically there is no such link between these elements.
Statistical and Economic: Furthermore, it has been suggested that apart from the purchasing power of currencies, factors such as rate of tariff, speculations in the market along with the rate of capital flow has a significant impact on the rate of exchange of the countries (Prodan, 2012).In the view of Qian (2010), purchasing power parity can take two different such as the absolute form of PPP and the other type is the relative form. It is further stated that the absolute form highlights that similar commodities in different countries need to be priced on equal terms when measured through the same currency. This form of PPP is also referred to as the law of one price. In the relative form of PPP, market imperfections are taken into consideration such as tariffs, transportation etc. (Özkan, 2013). According to Alba and Papell (2007), the concept of PPP is an extension of the concept of the law of one price. The law of one price illustrates that the price of a commodity or an asset will be the same when the exchange rates of different countries are considered. In accordance with Taylor(2003), the theory of purchasing power parity is based on the following equation:
S1 / S0 = [(1 + Iy) / (1 + Ix)]
The equation shows that the currency exchange rate between two countries is determined by the difference of inflation between the two countries as inflation leads to a reduction in real purchasing power of a currency (Taylor, 2003).
Problems and Issues Associated with Purchasing Power Parity
Statistical and Economic: One of the most important statistical issues is related to the adoption of the effective measurement techniques to identify whether the PPP concept has been effectively implemented or not (Alba and Papell, 2007). In the opinion of Taylor (2013), one of the major statistical difficulties, in this case, is related to multilateral comparisons when more than two countries are compared under the PPP concept. Furthermore, the statistical capacities of the countries that have been involved in this scenario are also critical in measuring the condition of PPP. It must be noted that the nominal exchange rates follow a random walk or non-stationary trend and on the other hand, the PPP concept perceives that the logarithm of the real exchange rate must be zero. Therefore, this is also a statistical problem due to which the stationary tests such as the autocorrelation is not applied to the PPP model and exchange rates (Taylor, 2013).In the view ofVoinea (n.d.), it is a noticeable aspect of the basic PPP equation that the differences between the inflation rate in the foreign economy and domestic economy (If – Id) is also non-stationary time series.
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