THEORIES OF PARITY AND THEIR USE TO DETERMINE THE TYPE OF

PROSPECTIVE EXCHANGE RATE AMONG TWO COUNTRIES

Silvia Aguilar - Natalia guarnizo

Is it possible that the theories of international parity are suitable and at the same
time effective predictoras of the exchange rate?; is it difficult to say that they are effective
and effective, but if certain conditions are satisfied in the handling of markets of financial
assets, is it may be possible to have an approach, is the objective of this article reason why
to be able to clarify if it is completed or not two of the most important theories in the
practice of the international financial administration, for we will take it the opinions of
certain experts in the topic, will we analyze the theory of parity of purchase power and of
interest, concluding if key factors exist in the execution of the same ones.

The Theory of the Parity of Power of acquisitive enunciated formally by Gustav

Cassel (1925) and defended by Yeager (1958) and Batchelor (1977), it settles down that
"the pattern of parity of the purchasing power is based in that the exchange rates between
two or more foreign currencies have to be in balance when the purchasing power is
identical in each one of the two countries". to be more explicit, the identical products
should have an unique price, in different countries in terms of oneself currency is already
Dollars, Eurus, Pesos, etc. With this theory, to determine the exchange rate between two
currencies, is enough to divide the price of a product in a currency for its price in another
currency, then an increase in the level of domestic prices of a country supposes a change in
its inflation rate, when this happens, it is expected that this rate is compensated by an
equivalent change but with sign opposed in the exchange rate.
The theory in the practice seems to be verified in the long term, but in the short one
there are many factors that impede its execution like tariffs, movements of capitals to short
and I release term, political of the governments, etc. The theory in question will be

completed when there is balance in the financial markets and the baskets of goods are
identical, situation that won't happen due to the inefficiencies of the market, the transaction
costs, the differentiation of the products and the restrictions to the international trade.

Let us see an example: Let us suppose that the value of a hamburger in Spain is of
2,56 and in the United States it is 2,51 $. so that the theory of the parity of the purchasing
power, the exchange rate of the euro with regard to the dollar is completed was of 1,02 /
$. This way, the country that has a bigger inflation differential will elevate the exchange
rate of its currency with regard to the other one, that is to say, it will recognize the loss of
value of its currency (depreciation).

The non fulfillment of the theory of parity generates opportunities for the arbitration
operations: to buy goods in a market where the price is lower and to sell in another market,
where the price is higher in terms of oneself currency. This is possible only in countries
with the same development level and with the same conditions so much climatic as cultural.
The theory of parity of types of interest exploded by Keynes (1930), it is based on
the concept "When a foreign currency experiences an appreciation or depreciation against
another foreign currency, this imbalance should be taken to the balance by means of a
change in the differential of types of interest". so that that happens, arbitration of covered
interest should be exercised that works in the following way: we request borrowed money
in a foreign currency, and next, we change it for other and we invest in active of debt; at the
same time, we buy contracts to term to convert the foreign currency again at the end of the
period. The quantity should be similar to the derived yields of to buy and to maintain active
similar of debt of the first foreign currency. The arbitration would take place if the yields of
both transactions were different, what would generate an utility free of risk. The
opportunity that offers the arbitration will disappear soon because the fact of being buying
and selling the same foreign currency makes him to be appreciated with regard to the other
currencies with those which you make trading.

To conclude, in the theories of the PPP and of the parity of the types of interest, the
essential element is the arbitration exercised by the economic agents, so much in the
markets of goods and services, like in the financiers. On the other hand, the interest rates in
the countries are different some of other and the investors continually compare them to
determine which of them it will provide them bigger yields; to compare them, they also
have to keep in mind the exchange rate among the foreign currencies of the evaluated
countries, this way they calculate the yield of the investments of a foreign currency with
regard to the other one.

Bibliography
BATCHELOR, R.A (1977) Sterling exchange rates 1951 1976: A Casselian analysis
National Institute Economic Review, 81, (August), pp.45 - 66
CASSEL, G (1925) Rates of exchange and power purchasing parity. Skandinaviska
Quarterly Report, (April), pp. 17 - 21
YEAGEL, L.B. (1958): A rehabilitation of purchasing power parity. Journal of Political
Economy, 66, (December), pp. 516 - 530
MADURA JEFF. Administracin Financiera Internacional en The Economist.com. (En
lnea) Abril 09 de 2002 . The Big Mac ndex