What do you understand by Purchasing Power Parity and Interest Rate Parity? Discuss the reasons for their deviations.

 Q. What do you understand by Purchasing Power Parity and Interest Rate Parity? Discuss the reasons for their deviations.

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are two foundational concepts in international finance and economics that aim to explain and predict the relationships between exchange rates, inflation, and interest rates across countries. Although both are rooted in economic theory, they are based on different assumptions and focus on different aspects of economic activity. The two concepts provide important insights into how international markets function and how the variables within them interact. However, both PPP and IRP are often subject to deviations in practice, due to various factors that undermine their predictive power. This deviation from theory has been a topic of significant interest and research in the field of economics.

Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory that suggests that in the absence of transportation costs and other trade barriers, the exchange rate between two currencies should equalize the price of a basket of goods and services in both countries. In other words, the theory asserts that the same basket of goods should have the same price when expressed in a common currency, regardless of the country in which it is sold. The essence of PPP is that the relative value of two currencies is determined by their purchasing power, and the exchange rate should adjust to reflect the difference in price levels between two countries.

The theory of PPP is based on the Law of One Price, which states that in a perfectly competitive market, identical goods should sell for the same price when expressed in a common currency. If this does not occur, arbitrage opportunities will arise, and market participants will exploit the price difference until the price parity is achieved. For instance, if a specific good is cheaper in one country than in another when the price is converted into a common currency, traders will buy the cheaper good and sell it in the more expensive market. This process will eventually lead to an adjustment in prices and exchange rates to reflect parity.

There are two versions of PPP:

1.     Absolute PPP: This version assumes that a basket of goods in one country should cost exactly the same as the same basket in another country when expressed in the common currency. Mathematically, this can be represented as:

S=P1P2S = \frac{P_1}{P_2}S=P2P1​​

Where:

o    SSS is the exchange rate between two currencies (currency 1 per currency 2),

o    P1P_1P1 is the price level of a basket of goods in country 1,

o    P2P_2P2 is the price level of a basket of goods in country 2.

According to Absolute PPP, the exchange rate should adjust so that the purchasing power of a given currency is the same across countries.

2.     Relative PPP: This version is more widely accepted and more commonly used in practice. Relative PPP suggests that the rate of change in the exchange rate between two currencies is proportional to the difference in inflation rates between the two countries. It holds that:

S1S0=(1+π1)(1+π2)\frac{S_1}{S_0} = \frac{(1 + \pi_1)}{(1 + \pi_2)}S0S1​​=(1+π2)(1+π1)

Where:

o    S1S_1S1 is the future exchange rate,

o    S0S_0S0 is the current exchange rate,

o    π1\pi_1π1 is the inflation rate in country 1,

o    π2\pi_2π2 is the inflation rate in country 2.

This version of PPP focuses on how inflation differentials between countries lead to changes in exchange rates over time.


Interest Rate Parity (IRP)

Interest Rate Parity (IRP) is another fundamental concept in international finance, specifically relating to the relationship between interest rates and exchange rates. IRP theory asserts that the difference in interest rates between two countries is equal to the expected change in the exchange rate between their currencies. In other words, the expected return on an investment in a foreign country, when adjusted for exchange rate changes, should be the same as the expected return on a domestic investment.

The central idea behind IRP is that arbitrage opportunities will prevent deviations from this parity. If investors can borrow in one currency, convert it to another, and invest at a higher interest rate, they will engage in currency speculation until the return on the foreign investment equals the return on the domestic investment. The IRP condition can be expressed mathematically as:

1+i1=(1+i2)×E(S1)S01 + i_1 = (1 + i_2) \times \frac{E(S_1)}{S_0}1+i1=(1+i2)×S0E(S1)

Where:

  • i1i_1i1 and i2i_2 are the interest rates in countries 1 and 2, respectively,
  • E(S1)E(S_1)E(S1) is the expected future exchange rate between the two currencies,
  • S0S_0S0 is the current exchange rate between the two currencies.

    The concept of IRP comes in two versions:

    1.     Covered Interest Rate Parity (CIRP): This version of IRP assumes that there is no risk of exchange rate fluctuations, as the forward exchange rate is used to hedge against this risk. Covered interest rate parity holds when the forward exchange rate locks in the future exchange rate, ensuring no arbitrage opportunities between the domestic and foreign interest rates.

    2.     Uncovered Interest Rate Parity (UIRP): This version of IRP assumes that the forward market is absent or irrelevant, meaning that investors are exposed to exchange rate risk. UIRP states that the expected change in the exchange rate should offset the interest rate differential. However, it does not guarantee that there will be no arbitrage, since exchange rate changes are unpredictable and may not match the expected movements.

    Reasons for Deviations from PPP and IRP

    Although both Purchasing Power Parity and Interest Rate Parity are fundamental to international economic theory, real-world deviations from these models are common. These deviations arise from various factors, including market imperfections, capital controls, government interventions, and other external shocks. Below are the primary reasons why PPP and IRP often deviate from their theoretical predictions:

    1. Market Imperfections

    One of the most significant reasons for deviations from PPP and IRP is the existence of market imperfections, such as transportation costs, tariffs, and trade barriers. These factors prevent the arbitrage process from fully equalizing prices across countries, which is a key assumption in the PPP model. For example, if there are high transportation costs or tariffs on goods between two countries, the price of goods in those countries may not converge, even if their currencies are theoretically aligned.

    Similarly, the IRP model assumes a perfect market where investors can freely move capital between countries. In reality, market imperfections such as capital controls or restrictions on foreign investments may prevent the free flow of funds, thereby causing deviations from the predicted exchange rate movements under IRP.

    2. Government Intervention

    Governments and central banks frequently intervene in currency markets, either directly through foreign exchange market operations or indirectly through monetary and fiscal policies. These interventions can prevent exchange rates from adjusting according to PPP and IRP. For instance, if a central bank wants to protect the value of its currency, it may engage in large-scale purchases or sales of its own currency, which can disrupt the equilibrium predicted by both PPP and IRP.

    Additionally, monetary policy actions such as interest rate changes can influence exchange rates in ways that may not align with the theoretical predictions of IRP. For example, if a central bank raises interest rates to combat inflation, the expected return on foreign investments may not align with the change in the exchange rate, especially if there is a significant delay in the market’s reaction to the policy change.

    3. Inflation Differentials

    PPP is based on the assumption that inflation rates between two countries will influence their relative price levels. However, inflation rates can be influenced by many factors, including changes in government policies, supply shocks, and fluctuations in commodity prices. In some cases, inflation rates may not reflect the true purchasing power of a currency, leading to deviations from PPP. For example, if a country experiences an inflationary shock due to an increase in oil prices, the currency may depreciate more rapidly than PPP would suggest.

    4. Exchange Rate Speculation

    The theory of IRP assumes that exchange rate movements are predictable based on interest rate differentials, but in reality, exchange rates are often influenced by speculation. Currency traders and investors may buy or sell currencies based on expectations of future economic conditions, political events, or even market sentiment, which can lead to exchange rate movements that deviate from the predictions of IRP.

    Speculation may result in excessive volatility or even bubble-like behavior in currency markets. This can be especially problematic in emerging markets, where exchange rate movements may be influenced by global investor sentiment, geopolitical events, and other risk factors that are not captured by the simple interest rate differentials in the IRP model.

    5. Political Risk

    Political risk, including instability, war, and changes in government, can lead to deviations from both PPP and IRP. Political events can cause shifts in investor sentiment, which in turn can influence exchange rates. For example, political instability in a country may lead to capital flight, causing a sharp depreciation of its currency, regardless of the interest rate differentials predicted by IRP. Similarly, political factors can affect inflation rates and disrupt the relationship between prices and exchange rates predicted by PPP.

    6. Capital Controls

    Many countries impose capital controls to limit the flow of foreign capital into or out of the country. These controls can take the form of restrictions on foreign exchange transactions, limits on foreign investment, or taxes on cross-border capital flows. Capital controls can create barriers to the arbitrage process that underpins both PPP and IRP. As a result, exchange rates and interest rate differentials may not align as predicted by the models.

    7. Expectations and Uncertainty

    Both PPP and IRP assume rational expectations, meaning that investors and consumers have perfect information and make decisions based on that information. However, in reality, expectations are often influenced by uncertainty, psychological factors, and market speculation. When investors are uncertain about future economic conditions, they may make decisions based on expectations that deviate from the fundamentals, leading to misalignments between exchange rates and the predicted equilibrium.

    For instance, if there is uncertainty about the future course of inflation or interest rates in a country, investors may act based on perceived risk rather than the economic fundamentals. This behavior can cause exchange rate movements that diverge from those predicted by PPP or IRP.

    8. Time Horizon

    The time frame over which PPP and IRP are expected to hold can also lead to deviations. Both theories tend to work better in the long run but may fail to predict short-term exchange rate movements accurately. Short-term fluctuations in exchange rates are often driven by speculative activity, market sentiment, and short-term capital flows, which are not captured in the long-term relationships predicted by PPP and IRP.

    9. Structural Differences

    Structural differences between economies can also lead to deviations from PPP and IRP. Factors such as labor market rigidities, differences in the degree of openness to trade, and the degree of economic development can affect the way that inflation and interest rates influence exchange rates. For example, developing economies may experience greater volatility in inflation and interest rates, which can lead to more significant deviations from the predicted relationships in PPP and IRP.

    Conclusion

    While Purchasing Power Parity and Interest Rate Parity are crucial concepts in understanding exchange rates and international financial markets, their practical application is often limited due to various factors. Deviations from PPP and IRP occur because of market imperfections, government interventions, capital controls, political risk, inflation differentials, and speculative behavior. Additionally, deviations may arise due to the influence of structural differences and investor expectations. Despite these challenges, PPP and IRP remain important tools for analyzing exchange rates, as they provide a theoretical framework for understanding how prices and interest rates should adjust in the absence of disruptions.

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