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BUSN601 Central Texas Purchasing Power Parity & Interest Rate Parity Response

BUSN601 Central Texas Purchasing Power Parity & Interest Rate Parity Response

Question Description

Hello,

I need four responses of at least 150 words each for the below students discussions for this week. Also in the bold below are the questions the students at answering.

Fortunately, the theories of both purchasing power parity and interest rate parity do not have any problems. Do you agree with this statement? In 250 words, defend your position.


Student one:

I will would like to state that I disagree with the statement that purchasing power parity and interest rate parity theories do not have any problems.

Whenever we want to compare money, we have two options to deal with it. One is purchasing power parity and exchange rate.

Purchasing power parity (PPP) is an economic theory that allows the appraisal of the purchasing power of various currencies to one another. It is the exchange rate that allows you to buy the same amount of goods and services in every country.

That means product between two countries should in essence be the same in the long run. Like a basket of goods that are traded between should cost same in different market. An examples is say, using a $100 to buy the same quantity of products in each country. Theory basically measures goods and services that can be bought with certain amount of money.

The Problems with the Purchasing Power Parity (PPP) theory is that the PPP condition is rarely satisfied within a country. (“Purchasing Power Parity theory video,” n.d.)

Among consumer goods and services items such as food, drinks, clothing, footwear, tobacco, rents, medical goods and services, water and gas supply, fuel, transport services, recreational and cultural services, education services etc will always vary from country to country which will not factor in demand and supply.

Interest rate parity theory on the other hand, refers to a condition of equality between the rates of return on comparable assets between two countries. So again in essence, the dollar interest rate on the U.S. and European bonds should be the same which is not the case.

References

British pound (GBP) and United States dollar (USD) Year 2014 Exchange Rate History. The Central Bank of the Russian Federation (CBR). (n.d.). Retrieved from https://freecurrencyrates.com/en/exchange-rate-his…

Park, D., Shin, K., & Tian, S. (2018). Do Local Currency Bond Markets Enhance Financial Stability? ADB Economics Working Paper Series. doi:10.22617/wps189596-2

Purchasing Power Parity theory video. (n.d.). Retrieved from https://www.bing.com/videos/search?q=Purchasing+Po…

Student two:

Good afternoon classmates,

It would be great to say that the theories of both purchasing power parity and interest rate parity don’t have any problems but that is not the case. I feel that the two parities are ‘good enough’ to make comparisons and accepted methods of comparisons. Purchasing power parity using the “basket of goods” method by comparing an exact group of items in a “basket” between two countries, priced the same in both countries and their respective exchange rates can compare the prices of good/services. The comparison cannot be done not equally. There is additional data that would need to be added to this calculation but it is a good way to get an idea of the cost comparison. This method is just not perfect or exact. There are additional things to factor in such as: “transport cost, tax differences, government intervention (tariffs), non-traded services, and market competition”. (Hall, 2019)

The interest rate parity theory is comparing the rates between two countries, assuming they are equal. It connects interest rates, spot exchanges and foreign exchange rates. (Hayes, 2019) The problem with using this is the constant change in the exchange rates and the forward rates which are predetermined rates for a contract. It seems like a good way to estimate the cost of an item or service but not a solid or very true over view. A limitation of the IPR is that of the “future or forward contracts that are not available to hedge, uncovered interest rate parity doesn’t tend to hold in the real world.” (2019)

There are too many variables that are not included when using the PPP and the IRP. This leaves for an inaccurate value for comparison.

Hall, Mary. (2019). What is purchasing power parity (PPP)? Retrieved from: https://www.investopedia.com/updates/purchasing-power-parity-ppp/

Hayes, Adam. (2019). Interest Rate Parity-IPR Definition. Retrieved from: https://www.investopedia.com/terms/i/interestrateparity.asp

Student three:

The theories of both purchasing power parity and interest rate parity are not free from problems. They both have their pros and cons and are capable of being used to their full potential depending on the market. Purchasing power parity is a theory that a specific “good” should be the same price no matter the location. This sounds good in theory, but this is not the case due to taxes, tariffs, and other ramifications. Though countries have working relationships with one another, they have to implement regulations that benefit themselves financially. Therefore, the prices cannot all be equal due to the markets in which the goods are being facilitated. The main factor that is involved in the purchasing power parity is the gross national product of a country. If you take one million iPad’s and sell them in Vietnam for $50 a piece; this wouldn’t seem outrageous for their economy. However, selling one million iPad’s in America for $50 a piece will not suffice. America has a higher cost of living and businesses need to make more for themselves and their employees to survive. Purchasing power parity has the end goal of placing the overall sale of goods into equilibrium (Jiang et al, 2015). Consumerism in America is also higher than a country like Vietnam and a device like an iPad can and should be sold for a higher cost.

Interest rate parity looks to put the rate of return on goods into equilibrium between two countries (Pipatchaipoom & Norrbin, 2010). Interest rate parity depends strongly on the bank of each country. Not all banks function exactly the same and two countries doing business with one another have to take that into consideration. A country with a high interest will have a higher value than the other country’s currency value. Taking that into consideration, this theory would hurt a country like America if they were doing business with a country like Macedonia. Both theories sound like great and simple ideas, but there is always more to business. All parties involved are trying to make a deal where they benefit the most. The difference in the currency of countries doing business with one another is never equal and it is all numbers game to come up with the best outcome. The above statement, when not looked at in detail, can lead one astray and cause the reader or businessman to not see the big picture when it comes to business.

References

Jiang, C., Bahmani-Oskooee, M., & Chang, T. (2015). Revisiting Purchasing Power Parity in OECD. Applied Economics, 47(40), 4323–4334. https://doi.org/10.1080/00036846.2015.1026592

Pipatchaipoom, O., & Norrbin, S. (2010). Is the real interest rate parity condition affected by the method of calculating real interest rates? Applied Economics, 42(14), 1771–1782. https://doi.org/10.1080/00036840701736073

Student four:

Macroeconomics is the branch of economics that studies behaviors and performance of an economy. It analyses broad range of indexes from price levels, rate of economic growth, national income, price levels, rate of economic growth, national income, gross domestic product (GDP) as well as changes in unemployment. With globalization and trade that aim at eliminating barriers while promoting exchange between partner nations, there is a need for a comprehensive mechanism to help measure or assure the flow of goods and capital. Purchasing Power Parity, an exchange rate determination theory aims at comparing prices of goods and services between countries. This theory is based on a variation of the “law of one price” which states that identical goods should sell for the same price in two different markets where there exist neither taxes nor transportation cost between the two markets. If we look closely at Mexico and United State, two countries of NAFTA, and we randomly picked a DVD at a local store in Houston, TX that sell for 15 USD (US Dollar). The same item sells for about120 MXN (Mexican Peso), considering the spot exchange rate of the current year (2019), the best rate is estimated at 20.1608 MXN to 1 USD. For simplified calculation purpose we will round it to 20. Quick mathematic dividing 120 by 20 gives us 6$. In other words, the same digital medium is almost 80 percent cheaper in Mexico City than in Houston, TX. If the theory of PPP held in this case, the prices should not have been different. One may be tempted to purchase as many DVDs as he could on his next vacation in Mexico and turn them in to profit once back on the main land. This will directly fall under the “goods arbitrage” where items can be purchased in one market at a lower price and sold in a different market for profit. Over time, as it becomes obvious that certain goods can be obtained at a relatively cheaper price, this could lead to price change driven by supply and demand.

Interest Rate Parity theory proposes a relationship between interest rates of two given currencies and the spot and forward exchange rates between the currencies. It assumes that the difference in exchange rate between currencies induces readjustment of the exchange rate. Another assumption of the IRP is the non-existence of arbitrage opportunities leaving investor indifferent as changes (excess or shortage) in deposits on one currency or the other are offset through devaluation or appreciation. If the political environment of one country changes, and the liberties of citizens are in jeopardy, this could affect the supply and demand of a specific currency in the global market. This external factor influencing the exchange rate parity theory negates the IRP’s assumption of induced readjustments. It will be hard to agree with the statement of PPP and IRP being problem free.

References

Manal, N. (2019, February 11). What Determines the Value of Currency? Retrieved from https://bizfluent.com/facts-4987763-what-determines-value-currency.html.

PPP. (n.d.). Retrieved from https://www.economicsonline.co.uk/Global_economics/Purchasing_power_parity.html.

US Dollar to Mexican Peso Spot Exchange Rates for 2019. (n.d.). Retrieved from https://www.exchangerates.org.uk/USD-MXN-spot-exchange-rates-history-2019.html.

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