Question

1. Briefly explain the international parity conditions in equilibrium. and  describe the relative purchasing power parity condition and comment it in terms of short-run and long-run.

Answer 1

Parity conditions in equilibrium

The parity conditions in equilibrium are conditions that establish linkage between financial prices in the absence of arbitrage.

It provides guidelines for financial strategic decisions suggested by each side of the parity condition.

The parity conditions

define international financial break-even points encompassing alternative strategies yielding identical financial outcomes suggested by each side of the parity condition.

From the private investors point of view, parity conditions help to make optimal (beneficial) financial decisions regarding the choice of currency for borrowing, location of plants in different countries, measuring currency risk exposure.

From public policymaker's point of view, parity conditions help to evaluate the strength of national currencies, the efficiency of national capital markets, and the effectiveness of fiscal and monetary policies towards achieving macroeconomic policies.

Relative purchasing power parity

Relative purchasing power parity states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

The disparity between the inflation levels of the two countries and the cost of imports would cause changes in the exchange rate between the two countries, according to the relative purchasing power parity (RPPP). RPPP builds upon the purchasing power parity principle and complements the absolute purchasing power parity (APPP) theory.

Its formula is:

S=P1/P2

where S is Exchange rate of currency 1 to currency 2

P1 = Cost of good X in currency 1

P2 = Cost of good X in currency 2