Exchange Rate Determination 1

International Finance

Submitted by: Furqan Hameed

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Date: 11/28/2020
Exchange Rate Determination 2

Purchasing Power Parity (PPP) is a theory in the economic field, which determines the
exchange rate[ CITATION Muh07 \l 1033 ]. To completely comprehend the fluctuations in the
exchange rate, one must have a complete understanding of the Purchasing Power Parity (PPP),
which explains the exchange rate and assess how the exchange rate is affected over time. To
attain sustainable payments in the field of business and finance, PPP can be used to model the
theories of the exchange rate, choose the targets for money and inflation, and assessing the value
of the exchange rate. To do all this, PPP tracks and keeps a record of all the flow of goods and
services. This theory also ensures that a fair price level is maintained when free trade is practiced
in two countries. It also follows the principle of the law of one price in the business world. When
relative prices are changed or varied, the Purchasing Power Parity can correct the dynamics of
the exchange rate, both in the shorter and longer run.

The main principle behind the Purchasing Power Parity is the trading off of goods to
equalize prices, with the condition of prices given in the same currency[ CITATION Muh07 \l
1033 ]. It also links the exchange rate to the prices. The law of one price (LOP) forms the
foundation of the Purchasing Power Parity, which claims that the trade between countries should
have the same prices in different countries when the market and trade is not highly competitive.
It focuses on the ideal condition of the trade-off of goods. Trade-off usually results when people
in the business world exploit the prices of goods to attain maximum profits. Therefore,
Purchasing Power Parity (PPP) ensures that a common and unified price is given for a certain
good in the countries that participate in the trade. But in reality, different goods in different
countries have varying prices in different currencies because of the demand and taste and needs
of people, which is different in one country from the other. in trade, transport costs must also be
included and the effects tariff has on the goods must be considered. The price difference between
the two trading countries is also generated owing to non-traded goods [ CITATION Muh07 \l 1033 ] .
Also, if the exchange rate is flexible, the theory of Purchasing Power Parity (PPP) is rendered
valid.

Purchasing Power Parity (PPP) theory also finds the errors in the exchange rates and tries
to correct them in the follow-up procedures. Once corrected, the exchange rate cannot go back to
maintain equilibrium. Corrections in the exchange rate ends with price levels increasing or
decreasing to ensure that in the longer run, for the maximum period, an equilibrium is
Exchange Rate Determination 3

maintained. However, there is a likely possible change for PPP to deviate due to either of the
structural factors or transitory ones. If there is variation in the structure, there is a high possible
chance of trends to diverge. A fine example to explain this would be the difference in
productivity growth in a country, which would increase the exchange rate. Further explaining
this point, when productivity is improved and increased in a country, it gives rise to the increase
in the value of the currency of that specific country, against foreign currency. Hence,
productivity can be affected by the use of technologies, policies, and growth of labor along with
better techniques, which could help bring about a complete change, to be precise, an increase in
the productivity growth of the country and hence, an increase in the exchange rate.

Transitory deviations rise because of the disturbance in the speeds of goods, with the
adjustment of the economy with it, and is usually a result of a non-ideal competition and
stickiness of price. Deviations can be prolonged and systemic stability in deviations can be
achieved if the goods market adjusts price slowly and the capital market is integrated
simultaneously.

Large deviations can be observed in the exchange rate from the Purchasing Power Parity,
at empirical levels, because of difficulty in statistics. For example, the price index cannot be
measured accurately, which directly affects the studies of calculating inflation rates in the
country. The items which are not traded allows PPP to carry on, such as those which cannot be
moved, or those which can be perished easily. So, PPP is can be different depending upon
different countries and goods. Developing countries like Pakistan depend upon international
trade for maintaining a stable economy, and exchange rates for a long time. Purchasing Power
Parity (PPP) holds in the longer run, as confirmed by many economists. Even by trading off of
goods, small deviations caused by licensing fees of imports, transportation costs, tariff payments,
and foreign exchange cannot be corrected by Purchasing Power Parity (PPP). However, PPP is
successful when the countries participate in mutual trade and geographical proximity and have
higher trade links[ CITATION Muh07 \l 1033 ]. Exchange rates are also adjusted by the stickiness of
the price. In short, PPP is not very successful in the shorter run but can have positive effects in
the longer run.

When experimented, exchange rate and price show the occurrence of cointegration,
claiming that it produces stationary residual. Experimental analysis from the year 1982-2005
Exchange Rate Determination 4

shows that the deviations from PPP are corrected within three months. Further analysis shows
that since the year 2000, the exchange rate can be improved and increased by the free-floating
exchange rate. The results of the experiment successfully explained that the Purchasing Power
Parity holds in the longer run, for Pakistan, especially by the result obtained which confirm
barriers to practicing free trade, different tastes of people in different countries, underdeveloped
markets, varying consumption patterns, price stickiness, transport costs, and fondness for goods
that are not traded, and consumed.

Error correction was also experimentally observed. The results of the error correction
method prove that when exchange rates are changed, which are lagged by one period, it directly
affects the present changes in exchange rates. This further goes on to prove that when exchange
rates are decreased or depreciated, it depreciates the value of the Pakistani rupee.

The whole idea of the research paper was to understand if the Purchasing Power Parity
holds for an underdeveloped country like Pakistan. A data was collected to check the validity of
PPP for Pakistan for the years 1982 till 2005. The exchange rate was tested as to whether it
remains stationary or moves, however, the stationarity test came out to be negative for Pakistan,
i.e. according to this test, PPP does not hold for Pakistan. But, according to the cointegration test
performed on the values, one cointegrating factor supported PPP, i.e. according to that specific
cointegrating vector, PPP holds for Pakistan. To further ensure the strength and accuracy of the
cointegrating test previously performed, another test, Autoregressive Distributive Lag (ARDL)
was also performed. It is another cointegration technique. According to the ARDL test, PPP
holds for Pakistan, making it the second test to confirm the Purchasing Power Parity and its
effect on the exchange rate in Pakistan.

The results of the study confirm the proportionality proposition, because of the
cointegration of nominal exchange rate and price levels. Purchasing Power Parity (PPP) can be
present in trading because of the economy and the government of Pakistan [ CITATION Muh07 \l
1033 ]. Trade links with developed countries are responsible for the economic development of
Pakistan which is why PPP holds for Pakistan. Also, the government of Pakistan is making
efforts and continue to improve the policies, especially in the fields of trading and finance to
eventually free the exchange rate. Since the 1990s, Pakistan has come far in making exchange
rate and finance free of bound policies. It has been possible because the government has lifted
Exchange Rate Determination 5

the price control policies for trade. This has only helped trade and have a positive effect on the
LOP and hence the PPP for Pakistan.

Also, Purchasing Power Parity (PPP) has been observed to be holding for Pakistan, and
its validity only shows the unified and integrated goods market. Deviation has been observed in
the short run in PPP but the validity of PPP in the longer run neutralizes the short term deviation.
Error correction is slow, as is proven by the small size of the error correction term. Therefore,
errors are corrected but it takes time to attain equilibrium. However, short-term deviations can be
adjusted by increasing the exchange rates which can be increased by adding some flexibility to
the prices.

To conclude, the Purchasing Power Parity holds for Pakistan in the longer run, which
adjusts the exchange rate. Growth should be controlled if domestic prices are to be increased and
stabilized. Monetary policy cannot be run independently, owing to the unifying of the foreign
exchange market and the goods market. The gist of the paper might be a warning that if the
exchange rate is decreased, the value of the Pakistani rupee is also depreciated.

Works Cited
Khan, M. A., & Qayyum, A. (2007). EXCHANGE RATE DETERMINATION IN PAKISTAN:
EVIDENCE BASED ON PURCHASING POWER PARITY THEORY. Pakistan
Economic and Social Review, 181-202.