INTRODUCTION: Macroeconomics is a branch of the economy which studies the economy as a whole and therefore it can accurately compare and differentiate between the economies of two different countries.
Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time. One popular metric is purchasing power parity. Purchasing power parity is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services.1 When a country’s domestic price level is increasing, that country’s exchange rate must depreciate in order to return to the Purchasing Power Parity. Purchasing power parity is used worldwide to compare the income levels in different countries.
Purchasing power parity thus makes it easy to understand and interpret the data of each country.2 Let’s say that a Parker Ink Pen costs Rs. 250 in India. Then it should cost $5 in America when the exchange rate is 50 between the dollar and the rupee. The exchange rate is determined between any two currencies by relative money demand and money supply between the two countries.3 A fall in the external purchasing power or external value of rupee, lets say a fall in exchange rate from Rs. 80 = $1 to Rs. 90 = $1 amounts to depreciation of the Indian rupee.
Consequently, an appreciation of the Indian rupee occurs when there occurs an increase in the exchange rate from the existing level to Rs. 78 = $1. Based on this, economists have come up with a light hearted index based on the basket of goods and purchasing power parity which can also determine how undervalued a currency is currently as against any other currency. Mostly, it is measured in dollars. This index is known as the BigMac index.4 Though there are many problems with the BigMac index, the theory which it is based on has legitimacy. So therefore in this paper the researcher will focus on the theory of purchasing power parity which is used to calculate the exchange rate and its benefits, criticisms and limitations and is it actually a feasible and practical way to calculate the actual devaluation of a currency against a dollar. STATEMENT OF PROBLEM OF RESEARCH· The problem of research is that the theory of exchange rate determination on the basis of purchasing power parity does not take many factors into consideration and also does not explain the short term tendency of the exchange rates.
In the recent times empirical evidences have backed long term explanation put forth by the purchasing power parity and so as to confirm that.5· To answer the question that can purchasing power parity predict the real value of the currency and if so then can according to Purchasing power parity, it be determined that by how much are currencies overvalued or undervalued?· Are the assumptions which the purchasing power parity based on unrealistic in nature and therefore purchasing power parity is a highly theoretical concept? REVIEW OF LITERATURE The researcher has reviewed the big Mac index which is published yearly by “The Economist”. In this, a McDonald’s burger is taken as the basket of goods. In this study, economic staff compare the price of above are in different countries against the price of the dollar.
In the study, it shows that the rupee is currently undervalued as against the dollar as a burger is about roughly 40% cheaper than it is in the USA. Though this can completely not be trusted as the government indirectly control the price of the goods and they can tax the product at their discretion. The Big Mac index was invented by The Economist in 1986 as a light-hearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity, the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services which in this case, a burger in any two countries. The index has its flaws.
First, the Big Mac’s price is decided by McDonald’s Corp. and can significantly affect the Big Mac index. Also, the Big Mac differs across the world in size, ingredients, and availability.6 The researcher has also reviewed a research paper titled “Purchasing Power Parity and Real Exchange Rates” by V. Anton Muscatelli from University of Glasgow and Franco Spinelli from University of Brescia. In this study they have observed long term data and also present empirical evidence on the purchasing power parity hypothesis using a new data set from the late 19th century for a number of major currencies.
AIM AND OBJECTIVES The aims and objectives of this research are· To study that how can purchasing power parity be an Alternative to Market Exchange Rates· To study the BigMac Index· To study the way exchange rates are calculated on basis of purchasing power parity· To research on whether purchasing power parity actually show the undervaluation of a currency· To study the Difference Between GDP and GDP Accounting Purchasing power parity HYPOTHESIS The researcher believes that the Purchasing power parity is a highly theoretical concept and that the assumptions it is based on are also not practical in nature and therefore the purchasing power parity is a partly theoretical concept but it can explain some long term behaviour of exchange rates. METHODOLOGY The researcher has used only secondary sources of data as for the completion of this paper. The researcher could not use primary sources of data due to time constraints and as the topic of the paper was very vast in nature as it was based on the economies of different countries, the researcher could not conduct any observations thus had to heavily rely on secondary sources of data and believes to the best of his knowledge all the secondary information to be true. LIMITATIONS The limitations of the research are that due to paucity of time and the huge scale of the workings of the economy the researcher has only analysed secondary sources and has not done any empirical work. Also as the purchasing power parity theory suggests that all currencies valuation were at a point of equilibrium at a time but as it cannot be traced back it becomes a huge limitation of the research and also a subsequent criticism.
1 Purchasing Power Parity. Accessed January 21, 2018. http://fx.sauder.ubc.ca/PURCHASING POWER PARITY.
html.2 “Definition of Purchasing Power Parity | What is Purchasing Power Parity ? Purchasing Power Parity Meaning.” The Economic Times. Accessed January 21, 2018. https://economictimes.indiatimes.com/definition/purchasing-power-parity.
3 Exchange Rate Determination. Accessed January 21, 2018. https://www.colorado.edu/economics/courses/econ2020/6550/section3/exchange-rates.html.
4 “The Big Mac index.” The Economist. January 07, 2016.
Accessed January 21, 2018. http://www.economist.com/content/big-mac-index.5 “15 Criticisms Against the PURCHASING POWER PARITY Theory (With Figure) | International Trade.
” Your Article Library. February 18, 2014. Accessed January 21, 2018. http://www.yourarticlelibrary.com/international-trade/15-criticisms-against-the-purchasing power parity-theory-with-figure-international-trade/26060.6 Investopedia.
“What Is Purchasing Power Parity? (PURCHASING POWER PARITY).” Investopedia. April 05, 2017.
Accessed January 21, 2018. https://www.investopedia.com/updates/purchasing-power-parity-purchasing power parity/.