International Finance
1. Implications of Deviations from Purchasing Power Parity for Countries’ Competitive Positions in the World Market
The Purchasing Power Parity (PPP) theory emphasizes that differences between exchange rates among two countries are in equilibrium if the purchasing power is same in both the economies. If rates of exchange between two countries are able to satisfy this parity, the competitive position of these countries remain neutral. However, if PPP condition is not satisfied, changes in exchange rates will affect the competitiveness of every country. For instance, if a country’s currency rate appreciates in value by more than what is warranted by PPP, it will find difficult to export local products.
Resultantly, the competitiveness of a country and its products’ financial worth hurt in the global marketplace. In the same manner, if a country’s currency depreciates without satisfying PPP condition, its global competitiveness would increase in the internal market due to lower cost of imports and increase in proceeds from export activities. PPP theory discourages unfair advantage by speculators/arbitrageurs and provides pure liquidity to market on basis of transparent supply and demand. Uniformity in purchasing power and market competitiveness, based on exchange rate changes, is the basic concept of PPP theory. This is because it reduces possibility of misleading international comparisons concerning exchange rate movements and purchasing power.
2. Explanation of Purchasing Power Parity (PPP) Concepts
This concept states that any commodity and security will have the same price in different countries when respective domestic/local countries are translated in one currency. This is due to arbitrage investment opportunities. If prices of commodities or assets vary across markets in different countries, speculators will purchase them from markets where prices are cheap and sell these assets or commodities to markets where prices are high. Law of one price advocates that product prices should be the same across different countries.
Absolute PPP
This concept stipulates that basket of goods should have identical price level in different countries when the relative price level is measured in a common currency. In other words, same goods and services should cost the same when they are translated in one common exchange rate.
Relative PPP
This concept concerns the differences in inflation rates between two countries. Suppose, inflation in country-A is higher than that of country-B resulting in price level of bundle of goods to rise in country-A. As per PPP-theory, such price level for basket of goods should be the same on both the countries. Therefore, the currency rate of country-A should depreciate in value relative to that of country-B and vice versa.
3- Benefits and Costs to an FI of Holding Large Amounts of Liquid Assets and Reason for Treasury Securities being a Liquid Asset
One major benefit that Financial Institutions (FIs) hold large amount of liquid assets as reserves is that it becomes easier to cover unexpected withdrawals from clients without liquidating or selling any asset. Another benefit is that, by holding larger liquid assets in their vaults to meet immediate financial obligations, Financial Institutions (FIs) do not need to consume emergency funding. At the same time, as highly liquid assets are risk-free, easily convertible to cash and return on investment is lower, Financial Institutions (FIs) take conservative buying positions and keep them for meeting financial obligations.
Treasury securities are considered highly liquid assets all across the globe because they are risk-free and can be easily as well as are readily convertible to cash. Holders of treasury securities do not need to sell these assets at a reduced financial worth, at discount or Forced Sales Value). One of the good examples of such securities is the Treasury Bills (T-Bills) traded by every Central Banking authority of every economy on behalf of the Government to raise capital. However, one cannot say that treasury securities are completely risk-free. Thy only contain sovereign-risk and are referred to as risk-free assets as governments never default on their obligations.
