Discuss the following topic:"Does Purchasing Power Parity (PPP) eliminate concerns about long-term exchange rate risk?" One of the most popular and controversial theories in international finance is the Purchasing Power Parity Theory, which attempt to quantify the inflation-exchange rate relationships. Much research has been conducted to test whether PPP exists. For example, Mishkin (1984), Adler & Dumas (1983), and Abuaf & Jorion (1990) have found evidence of significant deviations from PPP that persisted for lengthy period. A related study by Adler & Lehman (1983) provided evidence against PPP even over the long term.Hakkio (1986), however, found that even when an exchange rate deviated far from the value that would be expected according to PPP, it moved toward that value. Although the relationship between inflation differentials and exchange rate is not perfect even in the long run, it supports the use of inflation differentials to forecast long-run movements in exchange rates.
Instructions:
1- To read the point and counter-point of this argument and express your own opinion on this topic :
Point: Yes
Studies have shown that exchange rate movements are related to inflation differentials in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the dollar. A subsidiary in that country should generate inflated revenue from the inflation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects
Counter-point: No
Even if the relationship between inflation and exchange rate effects is consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a high-inflation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each multinational firm's situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in a multinational firm's stock may be concerned about short-term deviations from PPP, because they will not necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner that reduces the volatility in their performance in short-run and long-run periods.