Purchasing power parity is an economic theory t/ Finance
Read the 2 posts (1 and 2), and In responding to the posts, consider the case of Japan instead of China. Do you think your answers would be the same, and why? Answer each post with a small paragraph.
1)Purchasing Power Parity is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power. That is, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency. If trade barriers and government intervention were removed between the United States and China PPP will not consistently hold because there are many other factors which influence exchange rates such as inflation. Inflation rate between China and the USA is very different. It is much higher in China making its currency weaker compared to the US dollar. As today is 6.52 is equal to $1. Which means if a Mc Chicken is $1 here, it should cost 6.52 Yuan in China.
The International Fisher Effect (IFE) is an economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries’ nominal interest rates for that time. For example, if China’s interest rate is 10% and USA’s interest rate is 5%, the dollar should appreciate roughly 5% compared to China’s currency.
PPP and the IFE play a significant role in the exchange rate forecast. PPP is not useful for predicting exchange rates on the short-term basis mainly because international commodity arbitrage is a time-consuming process. PPP is more useful for predicting exchange rates on the long-term basis. As for the IFE for these two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates.
2) If trade barriers were completely removed and there were no government intervention between the United States and China, there would be a change in international trade result from inflation differences and affects the exchange. The effect on the exchange rate is more likely to occur if free trade is allowed and the currency’s exchange rate is allowed to fluctuate without any government intervention (SWlearning.com). In general, the rate of interest is an indicator of the level of inflation in a particular country. Thus, a country with higher interest rates experiences higher inflation and therefore, has a weaker currency compared to the country with lower interest rates. The rate of inflation in China is generally greater that in the US. This means that China has a weaker currency compared to the US. In this regard, the IFE would hold between China and US. Given the current situation, which involves the trade barriers and numerous government interventions, it is worth noting that the IFE and PPP do not offer accurate forecast on the exchange rate (Gaspar, 2016). The underlying force of International Fisher Effect is the disparity in expected inflation between two countries, which can affect trade and capital flows (SWlearning.com). The effects on the exchange rate are more likely to occur if free trade is allowed, and the currency’s exchange rate is allowed to fluctuate without government intervention.
On another note, providing the accuracy of the exchange rate forecast between the Purchasing Power Parity (PPP) (not as accurate) and IFE (more accurate) is tricky because the PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. The purchasing power parity or PPP refers to the level of adjustment required on the exchange rate between any two countries so that the rate of exchange is relative to the country’s currency power (Gaspar 2016) This explains why the rate of currency exchange rate operates at such a similar commodity in the two countries would cost the same amount of money. According to Gaspar, in the absence of trade barriers and government interventions, the PPP would not hold between China and US. This follows from the fact that in China, the cost of living is lower and therefore it is not easy to let the price of a particular commodity in the US to cost the same amount of money in China.
