Exchange Rate Mechanisms and the Purchasing Power Parity
Purchasing Power Parity (PPP) theory, which stands as nominal exchange rate theory, is the conception that a dollar should buy the same amount of things in different countries. According to this theory, exchange rate variations should move with the price level differences in different countries. In the long run, the exchange rate, i.e. for two different countries, should move toward a rate that equalizes the price of a similar basket of services and goods in them.
In other terms, this simple theory, states that two countries’ ratio of aggregate price levels should be equal to nominal exchange rate between the two currencies. Thus, each currency should hold the same “purchasing power” when used in the “foreign” country.
The famous economic magazine “The Economist” proposed in 1986 the mentioned “similar basket” can be the Big Mac hamburger from McDonald’s. The index is called “The Big Mac Index” and the interpretation is, using PPP theory, if the index is the nominal exchange rate, the Big Mac hamburger should cost the same in the U.S.A. as in a foreign country. This index has the advantage that is produced in approximately 120 countries and it differs from other indexes because the Big Mac production technology is similar in all countries. Also the production methods have not changed across time. Lined with this, the Big Max Index is achieving academic relevance. Mankiw (2002) analyzes this index in his book “Macroeconomics” and Li Lian Ong, from the International Monetary Fund, states that the index “has been surprisingly accurate in tracking exchange rates in the long term”.
Uses of PPP
Comparing exchanges rates with the PPP, for a given aggregate price level, shows when a currency is over or under valuated. This shows that any variation from the currencies’ parity would leave place for the appearance of arbitrage.
Despite this, PPP theory is not free of critics about its accuracy. PPP could fail for various reasons, e.g. nontradables, trade barriers or pricing to market.
Related with the paragraph above, Caetano, Moura and Da Silva (2004) found that “less productive countries tend to have currencies that are undervalued on a PPP basis”, and that “countries that are more opened to trade show less deviations from PPP”. These findings are important, even though they reflect previous theories, when using the PPP for financial planning or analyzing countries’ policies issues.
Mankiw (2002) points that “goods are not easily traded” and that even “tradable goods are not always perfect substitutes”. This is why real exchange rates fluctuate over time. However, the theory provides an explanation “why movement in the real exchange rate will be limited” (Mankiw, 2002). This is why there are reasons to expect that movements in real exchange rates should be small and they should not extend over long periods of time.
Stated a small explanation of the PPP theory it is interesting to see which uses or implications it has for global finance.
Uses in global finance
One of the key issues in International Finance is its use as a way to explain or anticipate exchange rates and their movements. The PPP theory has many remarkable applications on this topic, giving some answers on how the exchange rates move or adjust.
For example, for countries with fixed exchanges rates need to distinguish their equilibrium exchange rate. Similar to this, countries with variable exchange rates need to know the size and variations in nominal and real exchange rates that might take place. On an aggregate level the PPP can help in identifying disturbances and disequilibrium in the international macroeconomic system. For example, Dornsbuch (1982) in a research performed in the 80s found that “purchasing power parity oriented exchange rates policies have been widely adopted among developing countries as a way of isolating the foreign trade sector from the vagaries of the macroeconomy.”
Traders, i.e. international arbitrageurs, are sensitive to movements in the real exchange rate. Thus, movements in the PPP will act as an incentive (disincentive) for them to export or import goods from abroad.
This approach shows the importance of the PPP theory to explain the exchange rates movements. The logic that supports is simple: the farther the real exchange moves from the level calculated with the PPP, the greater the incentive encompassed for economic agents to trade goods internationally.
Zussman (2002) performs an interesting approach related to the effectiveness of the PPP analysis, as stated before, pointing that the opportunity for arbitrageurs are limited by frictions in markets. The line of reasoning is that the presence of trading frictions will set a “band of inaction around the PPP relationship”. Thus, when deviations from the PPP are “large enough to fall outside the band tend to be arbitraged away rapidly”.
In a similar analysis, using the Big Mac Index, Robert Cumby (1996) found that “deviations from relative Big Mac parity appear to provide useful information for forecasting exchange rates”. Further, in his research he established some levels: “After accounting for currency-specific constants, a 10% undervaluation according to the hamburger standard in one year is associated with a 3.5% appreciation over the following year”.
Importance in managing risk
The PPP theory might suggest that foreign exchange is not of importance for a firm when international markets are in equilibrium, but deviations from PPP can persist for long periods of time. Generally, when analyzing the exchange rates, PPP is evaluated with interest rates and inflation rates.
The importance of the section above is that the exchange rate exists when the changes are unanticipated. If changes are anticipated there is no risk.
For a given firm, the impact of currency movements on the values of cash flows, liabilities and assets might be significant. When a firm operates internationally, PPP could be of importance in setting the methods to measure the exchange risk that it faces. After this, taking account of the nature of the firm’s risk it must set up methods to forecast the currencies movements and, therefore, set an exchange risk management strategy. All this analysis will provide the information for a better decision making and choose which of the existing tools for managing risk it must deploy, e.g. debt policy, options, forwards and futures, etc.
Rogoff (1996) in an influential paper describes the “purchasing power parity puzzle” where he states the complexity of merging high short term volatility of real exchange rates with slow rates of mean reversion, i.e. following a disruption the real exchange rate should revert in the long run to the mean. This clearly sums up the complexity of the PPP theory, besides its simplicity of calculation, and thus implies that interpreting and using it is not an undemanding task.
In the long run, at the firm level, arbitrage and competitive forces should counterbalance the effect of exchange rates movements on the assets’ value. Coupled with this is that it also should neutralize the effect on the firm’s value. On the other side, it has been stated that disturbances can persist in the short run and they can last for extended periods of time. This is why it is crucial to keep track of the real exchange rates movements, to maximize the firm value, to take advantage of macroeconomic situation and to minimize the risks involved.
The PPP theory is an appealing tool to forecast foreign exchange rates, therefore managing the exposure to the risk of foreign exchange rate deviations. Hedging strategies to reduce currency exposure should also take account, besides the PPP, of the Fisher Effect -real rates should be the same worldwide-, the Interest Rate Parity –interest rates depends on forward and spot rates- and the assumption that market rates reflect all the relevant information.
Caetano, Sidney, Guilherme Moura, and Sergio Da Silva, Big Mac parity, income, and trade Economics Bulletin, Vol. 6, No. 11 pp. 1?8-August 26, 2004. Available at <http://www.economicsbulletin.com/2004/volume6/EB?04F30006A.pdf>
Cumby, Robert E. Forecasting Exchange Rates And Relative Prices With The Hamburger Standard: Is What You Want What You Get With McParity?, NBER Working Paper #5675 July 1996. p 13.
Dornbusch, Rudiger PPP Exchange rates rules and macroeconomic stability, The Journal of Political Economy, Volume 90, Issue 1, 1982, p. 158-165
Mankiw, Gregory N. Macroeconomics, Worth Publishers; Fifth edition (June 15, 2002)
Rogoff, Kenneth., The Purchasing Power Parity Puzzle Journal of Economic Literature 34, 1996, p. 647-668.
Zussman, Asaf The Limits of Arbitrage: Trading Frictions and Deviations from Purchasing Power Parity, SIEPR Discussion Paper No. 02-12, Stanford Institute for Economic Policy Research,December 2002 available at <http://siepr.stanford.edu/papers/pdf/02-12.pdf>
 The Economist, print edition, “McCurrencies”. Apr 24th 2003.