The effect of inflation & exchange rate on purchasing power parity

Background

The academic theory for the study of Purchasing Power parity and money demand is standard. The convenient way of PPP theory proposes merchandise market arbitrage encourages parity in national price level. Therefore, changed to a general currency, national price levels supposed to be equal.

Law of One Price

The establishment of purchasing power parity is ashore in the law of one price. The theory tells the complicating factors and excluding frictional such as duty, excise, taxes and shipping costs; in our country the price of globally trade goods should attain the matching price in other country, formerly the price is in tune to a ordinary exchange.

And so, the economic theories propose to two long-run relationships can be originate: one between foreign prices, national prices and the nominal exchange rate; and further among national prices,, real income, money and the nominal interest rate. although we would be expecting together the real money demand and real exchange rate to be comparatively steady in the long run, we could also suppose momentary deviations as of these two long-run balance to have an effect on upcoming fluctuations in the variables so as to the long-run equilibrium are restore.

These conversion, in addition to a few essential economic structural modifications, might cover debatably affect in cooperation the real exchange rate and the long-run money demand relationship, as it lead to together a few financial intensifying (as low-income households gained access to formal banking services to a larger extent), and a well increase in foreign contest, which in turn might have had a rarity effect on the domestic price level.

Theoretically, PPP’s are extremely related to CPI. The PPP’s procedures of price level differences across liberty or, in their most popular form, across countries. As the prices of goods and services in various countries are articulated in national currencies, suppose the number of units of currency of two countries are A (or B), and consumers power of affordability between the two countries are B (or A) that has the same consumers affordability as one unit of currency of country A (or B). The different countries can assume special significance because the PPP’s can be used conversion factor as a common currency unit in place of exchange rate because they assume special significance. However, the PPP’s are similar to price index numbers in assessment. These ordinary currency units are measured to be real value aggregates. These real aggregates make it feasible to undertake economic and statistical analyses on global and regional levels and undertake cross-country comparisons.

The buying power of various currencies is equalized for a particular basket of goods. In the “comparative” edition, the rate of changes in prices on home and abroad, the variation in the inflation rates is equal to the proportional decrease or increase of the exchange rate.

The well-known and mainly use purchasing power parity exchange rate is “international dollar”. PPP exchange rate (the “real exchange rate”) fluctuations are usually appropriate to different rates of inflation among the two economies. Aside from this instability, regular variations of the market and PPP exchange rates are observed, such as (market exchange rate) where incomes are lower prices are usually lower of non-traded goods and services. (U.S citizen in Pakistan exchanged more because of their spending power is more than a dollar spent in the United States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally.

Even though, it is necessary to realize that the PPP is a dominant tool to give us a familiar lens by which to look the economic strength and situation of various countries. Immediately at the same time with any device or tool, we have to be aware of the boundaries and limitation of PPP and recognize how we can manage those restrictions inside a particular data set.

1.2 Problem Statement

The period of PPP’s exchange rate can be extensive & expended. To understand some of the potential causes of these deviations it is handy to have a glance over the important imagination. We must make our mind before we could raise the Law of One Price for individual goods on which PPP is based.

Purpose of the Research Study

The purpose of the study is to know the effect of inflation & exchange rate on purchasing power parity.

This research report will help for understanding the Purchasing Power Parity and how its effect inflation, exchange rates will it changes country by country. This study relates to the consequence of PPP in explaining the exchange rates between the currencies of developed countries and of Pakistan. This research is based on the idea that how inflation and exchange rate exerts compels over the purchasing power parity. This report will adheres transpire the mitigations for importers and exporters. In broad sense, this will help the consumer and one interested in importing the products and commodities to estimate that how inflation can aggregate its impacts over their transactions. It will compel the corrosion of the frequent importers and exporters. Whereas, this research report will be beneficial for one’s studying or interested in inflation and economy. Corporate and many financial institutions performing the international transaction can mitigate and minimize their risk due to inflationary pressure over Purchasing Power Parity.

1.4 Research Question

What are the effects of inflation & exchange rate over PPP (Purchasing Power Parity?)

Effects aggregated in broader sense are negative and positive, whether the purchasing power parity shows its increasing trend or decreasing trend. Positive in the sense that the country can now buy more goods from another country with the same size of currency bucket as compare to later one, whereas, the negative effects indicates the devaluation and limitation of purchasing goods from another country, spending more as compared to previous one.

Limitation

Globally variation of data according to different regions.

As per the topic, the data gathered for inflation and exchange rate will be secondary data.

There are several approach is being used for test PPP like unit root test, co-integration test but for the convenient and availability of the data I used correlation between US and Pakistan CPI.

In this research, researcher used only one commodity to elaborate the purchasing power parity.

CHAPTER 02

LITERATURE REVIEW

Officer, (1982), as prescribed by the title of the study “Effects of inflation and exchange rate over purchasing parity”. It is clearly determined that the two adjacent bodies, exchange rate and inflation rate can be jointly counted which can affect the purchasing power parity, The report on integration of Inflation (CPI) and (PPP) concludes that Purchasing power Parity & Consumer price index exchange factors allocate theoretical resemblance. The PPP’s evaluate differences in levels of prices across countries or regions within a country whereas CPI evaluates changes in levels of prices of goods and services over time within a country. As a result the PPP’s and CPI submit, correspondingly, to the time and involving measurement of price activities. The CPI is one of the main commonly second-hand for economic indicators, compiled and distributed by national statistical offices on a standard basis. CPI procedures to play an important function in examine the effects of government policies, mostly financial policy, and present the general public with evaluate of changes in the prices of goods and services consumed. PPP’s explained as “the number of currency units required to buy goods equivalent to what can be bought with one unit of the currency of the base country; or with one unit of the common currency of a group of countries.

It is been observed that in most cases it was found at least one co-integrating vector matching PPP. In three cases, the results depended on using the countries’ interest rates to explain the deviations from the long-run relation implied by PPP theory. However, the application of PPP theory should not be “confined” to the search for long-run relations: it should also lead to the study of short-run dynamics whereas; the factor of inflation is always to be considered to alter the maximization of effects over purchasing power parity. As per other empirical studies for S. Africa, specify that be present a secure money demand sort of correlation between real income, domestic prices, broad money and interest rates, and a long-run relationship with nominal exchange rates, domestic prices, and foreign prices.

Within short run, shocks to the nominal exchange rate have an effect on local prices although no impact on real output, whereas shocks to extensive money contain a transitory impact on real output prior to fitting inflationary. Together shocks look like to activate a monetary policy retort, because the short-range interest rate regulate rapidly. S. Africa implements a proper inflation-targeting structure for monetary policy early in 2000, subsequently with a reduction of reasonable experiences through other monetary policy systems (for example an exchange rate peg and money growth targeting, for the period of the earlier debates. The inflation target was set at 3 to 6 percent by 2002, and transparency and accountability of the S. African Reserve Bank.

Anton, (2006), According to a study the research has determined the facts and the level of relationship between how the inflation can under its stemmed branches i-e WPI, CPI and SPI indices can affect the purchasing power parity and exchange rate. There are few economic theories that have received as much scrutiny as purchasing power parity (PPP) and the determination of long-run real exchange rates. There is a vast empirical literature on these two related subjects presented in the research report. The message which emerges from the existing literature by this report is that it has only a very partial picture of why deviations from PPP are so constant over time. The inability to fully explain the dynamics of real exchange rates stems from the imperfect knowledge of the dynamics of price adjustment and of the fundamental variables driving long-run relative prices in the world economy has been kept as the based foundation in this study. When it’s added to that an imperfect knowledge of the channels through which non-monetary shocks drive nominal exchange rates in the short run.

The aim here is not to offer yet another comprehensive review, but to justify the relationship and the emerging affects of inflation on Purchasing Power Parity with the real exchange rates. Exchange rates may change over time in response to a number of different forces. Prominent among these forces are: (i) Domestic compared to foreign inflation rates, (ii) Commercial polices of the Government, including tariff and non-tariff barriers to trade, and (iii) International movements of capital and incomes. Anticipating movements in each of the above exchange rates will require analysis of changes in these three critical sets of variables, which often will be causally related to each other. But here in this study the determination is about the changes that can be unveiled through the affects measured in this study. Moreover, it also provides a test of purchasing power parity (PPP) as an explanation for long term foreign exchange rate movements. It essentially extends the analysis of the South East Asian nations, Indonesia, the Philippines, Malaysia, South Korea and Thailand. It imposes symmetry and proportionality restrictions flowing from the absolute form of purchasing power parity (PPP). The tests are also run for sub-periods with similar results. Symmetry and proportionality restrictions find little support in the unit root tests though the Johansen tests suggest that the foreign exchange rate and inflation rates are linked in a long run sense. Anton, (2006), The description illustrates that there is strong evidence that PPP holds as a long run constraint in countries at a lower stage of economic development and characterized by under developed capital markets. For those countries that has substantial foreign exchange speculation and capital movements, the changes of exchange rate deviate largely from PPP. The research also shows the there is lack of evidence to support the conventional wisdom which predict that a large share of non tradable sector, severe trade restrictions and intensified government intervention in foreign exchange market would lead to a divergence between the exchange rate and PPP. Nevertheless, most of the results are based on the data of the major industrial countries. While developing economics share many common characteristics in terms of exchange rate determination, there are some major differences between the two types of economics.

Tang, M, (2005), this is simply the combination or effects gathered due to disturbance in inflation. As per the research, it has to be monitored that how the purchasing power parity is affected due to inflation and apparently the exchange rate. Whenever the inflation has aroused and sounded hyper, the exchange rate had showed a boosted move in the economy portraying the Purchasing Power Parity to decline. On the other hand, when it is said that inflation had decreased, it tends to appreciate the home currency resulting in incline in purchasing power parity because now the one in home country can achieve or being facilitated more if comparing goods from other country. In other words, a country who’s PPP had shown an incline can buy more goods from other country as from the factor of inflation and Purchasing Power Parity.

Mark J. Holmes., (2001), finds that there is no relation between Purchasing Power Parity confined to high inflation developing countries & their techniques use new econometric techniques.

Duo Qin & Tao Tan., (2008), investigates their study categorized into two types: short-run and long-run common currency shocks. These shocks are used as explanatory variables to model the inflation and intraregional trade growths of the country concerned. The resulting models provide us with a base to simulate and evaluate the counterfactual situation of how much inflation and trade growths would be affected by the removal of these shocks. Methodologically using the approach can be considered as a special case of the latent variable structural models used commonly in behavioral research. First of all, the regional long-run exchange rate variability covariates with the world exchange rate variability a great deal whereas the short-run exchange rate variability is mainly regional specific. Consequently, a currency union would result in reducing the intraregional short-run currency volatility risks without much loss of the regional capacity of assimilating disequilibrium risks from the world currency movement.

Results: Their dynamic modeling results show that the regional short-run shocks exert significant impact on the inflation and the intraregional trade growths of all the countries studied, overshadowing the impact found of the regional long-run shocks. They also find that the dynamic transmission paths of the regional shocks differ significantly from country to country. These finding makes it an oversimplified statement that smaller countries would benefit more than larger countries from a currency union. The benefit of a currency union is found, however, to be less substantial as far as the model-simulated magnitudes in inflation reduction and trade promotion are concerned. At the regional level, the magnitudes in trade promotion are much larger than the amount of inflation being reduced; at the country level, results vary and, in many cases, the benefits may not to be considered as substantial enough to warrant a vote for the union.

Muhammad Zakaria, Eatzaz Ahmad and M.Mazhar Iqbal., (2007), investigates the determination of bilateral nominal exchange rates of Pak-rupee against its twelve major trading partners using standard econometric techniques based on quarterly date for the period 1983-2004. The result shows that nominal exchange rates depend on a number of endogenous and policy variables linked toward Pakistan as well as its major trading partners. Particularly, the fluctuations preserve near by comparative inflation rate & nominal exchange rates at home and abroad, both governments’ monetary policies, terms of trade, trade policies and capital mobility. Their results also show that some controlled form of monetary policy may be useful for maintaining stability in exchange rates.

Adnan Haider, Safdar Ullah Khan., (2007), investigates determinants of financial via monetary inflation which gives a concise assessment of a number of preferred international and domestic studies. The assessment gives us the literature intended for Pakistan including studies which contain incorporated determinant in their form setup & those which use government borrowing as a determinant of inflation. In the case of Turkey, Akcay, Alper and Ozmucur (1996): Author explores inflation determinants by using annual data from 1948 to 1994 in comparison with quarterly data as of 1987 to 95. Author investigation tells that an increase of one unit in deficit GNP ratio in money neutrality determination raise the inflation rate in long-run with 1.59 units. Furthermore one unit raise the deficit GNP ratio in money neutrality will increase the inflation in long-run with 5.67 which lot higher than 1.59 in support of the entire model representing larger impact inflation deficit for the duration of pre-bond financing.

To find out the long run relationship with instability in government borrowing from central bank in Pakistan & inflation rates author using auto regression distributed lag mode in this research which results the feeble forecaster for upcoming inflation in economies & fiscal inequity under the study. Additionally, author fined that the expected increase in fiscal deficit circumstances in upcoming may probably impact in and inconsequential way towards mounting the inflation in economy.

Dr Abdul Qayyum, Muhammad Arshad Khan, Dr Khair-u-Zaman: derived that WPI ratio is co-integrated with nominal exchange rate & is close to one the coefficient limitations are tested using Johansen statistic ratio, provide support for the legality of the WPI-bases PPP. Their discovery is reasonably reliable in sight of Pakistan’s heavy dependence on the western industrial countries for the development of economic. In reality, Pakistan has been pursuing exchange rate and trade liberalization policies from the late 1980s. During improvement, Pakistan has effectively eliminated the majority liberalized trade and price controls. These exchange liberalization and trade policies permitted the one price law to work extra proficiently at the same time as revealed by the helpful proof of PPP. Additional, the inflation differential has adjusted by nominal exchange rate. Fiscal shock, reflected in terms of high inflation rate has been neutralized over the long-run. The short-run variation from PPP has repeatedly occurred but the long-run validity of absolute PPP possibly will not be rejected.

Shaghil Ahmed, Iffat Ara, Kalim Hyder., (2006), finds that effect on rises of prices through the inflation rate, indicating net exports show a predictable optimistic reaction to a real exchange rate reduction shock rather than exports rising largely driven by imports falling. However the encouraging outcome on net exports is more than counterbalance by slimming down effect on domestic inclusion, which results overall output in a net negative effect. If continuous maturity of policies & monetary frame work in Pakistan, one would maybe in time be able to provide additional incompetent suggestion for greater exchange rate flexibility policy. For this finding Authors use auto regression (VAR) methodology.

CHAPTER 03

METHODOLOGY

3.1 Introduction

The data that will be used for testing of high inflation and exchange rate on Purchasing Power Parity (PPP) is of 10 years. Since, to determine the effects on purchasing power parity, various commodities are necessary to be taken into account. In this report, to determine the purchasing power parity “Crude Oil” will be taken as a commodity.

3.2 Research Approach

A Quantitative approach is used to consider the only approach that gives an objective truth, as it transfers information into facts and figures. In this research focusing on effect of inflation & exchange rates to know the impact, and variables are in numeric so for that reason using quantitative approach.

3.3 Research Design

In this research Correlation technique is used to evaluate the relationship between dependent over independent variable.

Model

Y = Purchasing power parity is our dependent variable.

I = Inflation is our independent variable.

E = Inflation is our independent variable.

3.5 Hypothesis

H0: Effect of inflation & exchange rate on Purchasing Power Parity is significant.

H1: Effect of inflation & exchange rate on Purchasing Power Parity is insignificant.

3.6 Statistical Technique

Statistical technique Multiple Regression is used to test the variables

3.7 Data Collection & sources

Secondary data is used in this research. Date is gathering from JS Global research department & Library of State bank of Pakistan.