GLOBAL ECONOMY

Parity Theories and Global Economy



Parity Theories and Global Economy

Introduction

Parity theories presents a discussion of the essentials of the PPP doctrine, characterizing it as macro-economic and monetary in contrast to the balance-of-payments theory of the exchange rate. Currency crises remain a problem, sharpened by technology and globalization of capital. This paper analyse the need for and methods of interest rate and foreign exchange risk management. This paper presents a critical analysis using the parity theories and discusses the theory that has most relevance for a company operating in the global economy.

Parity Theories

Even with no reference to the productivity-bias hypothesis, parity theories author argues that PPP need not yield the equilibrium price or cost relationship; links of non-tradable prices with export and import prices are pertinent (Hakala, 2002, 15). Methodological sections exposit a three-way classification of PPP: absolute versus relative, domestic price or cost concept, and functional form of the theory (Afza & Alam, 2011; Carbaugh, 2010, 60). An entire chapter is devoted to empirical applications of PPP. The author failed to foresee that new econometric techniques would soon revolutionize empirical testing, and is perhaps too accepting of the usefulness of PPP and its robustness (Homaifar, 2004, 100). The history of doctrine, although it makes reference to the economic-historical background, does not place PPP within the broader analytical schemata of its adherents (Wang, 2009, 69).

He anticipates in noting high elasticity in the foreign-exchange market as an implication of the PPP theory. Misuse of PPP by policy makers in the interwar period is discussed, but Haberler concludes that PPP can have “considerable diagnostic value” if used cautiously. Omission of empirical testing is the only flaw in the presentation (Aabo et al., 2011; Grauwe, 2005; Poghosyan, 2009, 87).

The discussion is an excellent assessment of the methodology (but not history of doctrine) of PPP, including its limitations, and contains a survey of the empirical literature. Yeager also provides his own empirical testing of PPP in relation to fluctuating exchange rates after World War II (Hakala, 2002, 15). He deserves praise for correctly stating the following two test criteria for the theory: (I) correspondence of PPP with the exchange rate, which became known as the law of one price (LOP); and (2), direction of causation from price levels to the exchange rate. Empirical testing deals with the first criterion: the second is applied via economic argument supported by historical experience (Christensen, 2000; Maciulis, 2008, 270). Developing the relationship of PPP to Eli Hackscher's “commodity points” is an original contribution, and Yeager also sees the monetarist nature of PPP (Janabi, 2006b; Uppal & Apte, 1996).

Foreign Exchange

The foreign exchange rate is the price of one nation's currency in terms of another nation's currency (David, 2002; Stephen, 2001, 70). This is often called the “foreign exchange rate,” in that it is the price determined in the foreign exchange market when people buy and sell foreign exchange (Afza & Alam, 2011; El-Masry, 2006; Stephen, 2001, 70). The “numeraire” (or standard) of the international monetary system is the ...