Currency of the UK

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The history of Purchasing Power Parity (PPP) theory dates back to the Sixteenth Century scholars of the University of Salamanca. While the world saw its revival in the interwar period, it was broadly accepted in the post war periods, as a long term equilibrium condition. Some economists advocated the short term usage of this theory. Several researches and studies have been conducted in the last three decades and with the help of the findings from these studies, there emerged a situation which will enable the users to have a deeper understanding of how well PPP applies in both the short run and the long run.

Since the mid of 1990s the studies have been basing themselves on larger datasets and non-linear economic methods and thus have improved the estimation procedures. “As deviations narrowed between real exchange rates and PPP, so did the gap narrow between theory and data, and some degree of confidence in long-run PPP began to emerge again. In this respect, the idea of long-run PPP now enjoys perhaps its strongest support in more than thirty years, a distinct reversion in economic thought.

” (Alan M. Taylor and Mark P. Taylor 2004) Thus PPP theory has a long history in economics but, the specific terminology was introduced in the years after World War I during the time there were international policy debate concerning the appropriate level for nominal exchange rates among the major industrialized countries after the large scale inflation during and after the War.

“The question of how exchange rates adjust is central to exchange rate policy, since countries with fixed exchange rates need to know what the equilibrium exchange rate is likely to be and countries with variable exchange rates would like to know what level and variation in real and nominal exchange rates they should expect. In broader terms, the question of whether exchange rates adjust toward a level established by purchasing power parity helps to determine the extent to which the international macroeconomic system is self-equilibrating. ” (Alan M. Taylor and Mark P. Taylor 2004). This is the central theme of this paper.

With a statistical analysis of the exchange price fluctuations different currencies with respect to a single currency and the inflation rates during the same period, over a period of 10 years, this paper tries to establish a possible correlation between the exchange rates and the inflation rates. “The general idea behind purchasing power parity is that a unit of currency should be able to buy the same basket of goods in one country as the equivalent amount of foreign currency, at the going exchange rate, can buy in a foreign country, so that there is parity in the purchasing power of the unit of currency across the two economies.

” (Alan M. Taylor and Mark P. Taylor 2004). One simple way of gauging whether there are any deviations in the PPP, is to compare the prices of similar or identical goods form the basket in the two countries. Consider this example: The price of a cheapest burger in China in January 2004 was $ 1. 23 while the same was costing in the US at $2. 80. Therefore it implies that China’s Yuan was 56% undervalued. The average price in the European countries during the same period was $3. 48 meaning that the Euro was 24% overvalued against the US dollar.

Such comparative prices are given by the Big Mac Index and are being published in the Economist newspaper. A similar other index is the Tall latte Coffee from Starbucks which is being served all over the world. It may be noted that while these indices can provide a broader idea on the movement of the relative currencies in the international arena, they cannot be taken to provide an accurate measure of catching the trends in the foreign currencies, as these establishments do have extraneous considerations peculiar to the locales concerned.

Businesses can make risk-less profits by shipping the goods from the locations where the prices of goods are low to locations where they fetch higher prices which is known as ‘arbitraging’. Economists advocate that the PPP theory may hold good because of the presence of arbitraging which is related to the so-called Law of ‘one price’ which holds that the price of internationally traded goods should be the same anywhere in the world. The PPP theory may be an ‘absolute’ one or a ‘relative’ one

The purpose of this project is to define, try and test the Purchasing Power Parity Theory. As outlined in the introduction, this theory is the one most commonly used. Yet this theory has also been criticized a lot and also the PPP theory has been the subject of a lot studies and research in the field of Industrial Finance. Several tests have also been conducted on this theory to ascertain whether this theory can hold good. As theory it concentrates on the relationship between inflation and exchange rates.

The theory which is also known as ‘law of one price’ suggests that the products of a similar nature should carry a similar price when measured in one common currency. This theory suggests that the two countries ratios in price levels in one basket of goods should be equal and therefore the purchasing power should be equal. If there is a discrepancy in the prices measured in the common currency, then PPP theory states that there should be shift in demand so that eventually prices should converge.

In layman’s terms what the theory suggests is that a basket of goods for example in USA and UK once price of goods or services expressed in a common currency and the exchange rate is taken into account. When there are differentials in the price index this is known as either inflation or deflation dependant upon the change in the index. This project will be carried using data from various sources and information gathered from Perfect Analysis and other relevant books and websites. It will then be presented using Micro Soft Excel, MS Word and Mini-tab.

The intention is to establish what relevant significance the test has on the international finance, with rates of exchange and inflation being the predominant indicators of a country’s financial standing, an analysis of the relationship between them and the differential in them over time. We also aim to describe how markets behave in response to such variations. The project will aim to show whether PPP theory is true or not and shows its validity basing on the comparison of data from Perfect Analysis from Japan and United States in relation to the currency of the UK.

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