Reasons for “Misalignments”
Exchange rates which do not reflect the PPP value are said to be “misaligned” and it is assumed therefore that they have to revert towards PPP. Such misalignments are seen as being caused by temporary distortions, either to the price of the good or the exchange rate, which should quickly be eliminated by a rational, profit-seeking market. In reality, such “misalignments” can last for months or even years. In other words, traders, investors or corporations who base short-term financial decisions on the PPP model of exchange rate value do so at their own risk. The track record of the PPP model over the short term leaves a lot to be desired, to the extent it is known in the market as the “Pretty Poor Predictor”. How can such misalignments occur in a free market economy where the price adjustment mechanism should be immediate? If there is free trade between nations, a price differential in a good (or basket of goods) should create an arbitrage opportunity — you buy the good in the cheaper country. Such buying should push up the currency in the cheaper country relative to the more expensive one. Yet still, this is not necessarily what happens over the short term. Why?
We do not have perfectly free trade — Such a concept would imply zero import tariffs, zero export subsidies and perfect competition across all business sectors. Needless to say, this is not the case. Whatever progress we have made, we are not there yet. As a result, there remain significant trade-related price (and therefore exchange rate) distortions.
The adjustment mechanism is not necessarily immediate — During periods of market volatility, corporations may delay setting prices and budget exchange rates until they have a better idea of where the appropriate levels should be to retain competitiveness and margin.
The price of goods may not be the most important exchange rate determinant — A basic PPP assumption is that the relative pricing of goods is the main driver of exchange rates. However, since the liberalization of capital markets, this may no longer be the case.
The good or basket of goods may not be exactly the same in different countries — The consistency of the good should not be taken for granted as the same good may vary between countries in terms of quality, cost and speed to market.
Base-year effects — There is also the question of when to start the PPP analysis. Logic might suggest starting from the end of the Bretton Woods exchange rate system in the 1971–1973 period, yet this took place at a time of very high inflation, thus significantly distorting the results.
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