Understanding Purchasing Power Parity and International Monetary Systems

Understanding Purchasing Power Parity

General Idea

A country's currency value, with respect to another, is determined by its purchasing power.

Two Applications of Purchasing Power Parity

1. To determine the exchange rate parity of purchasing power and use it for comparisons of social accounting.
2. As a theory that explains the relationship between price levels and the exchange rate.

Factors Influencing Exchange Rate Fluctuations

Parity Adjustments

Persistent or fundamental imbalances in the balance of payments can lead to changes in monetary parity, or the external exchange value of a currency. Parity can be adjusted upwards (revaluation) or downwards (devaluation), depending on whether there is a surplus or a deficit.

Devaluation allows exporters to receive higher income in the national currency, impacting international price changes.

The International Monetary System (IMS)

• Regulates international commercial activity and financial data between countries.
• Manages payments and receipts arising from international economic transactions.
• Its main objective is to generate cash flow.

Structure of the International Monetary System

1. Adjustment: Addresses real imbalances, measured by the balance of payments, that affect the relationship between currencies.
2. Liquidity: Determines which reserve products to use, how to create them, and when to use them to address imbalances in the balance of payments.
3. Management: Divides and manages responsibilities among more or less centralized organizations, such as the current IMF and central banks in each country.
4. Confidence: Builds confidence in the stability of the system based on the previous three elements.

Secondary Functions of the IMS

1. Assigning Currency Seigniorage: Profits made by printing money or the difference between the cost of issuance and the value of money.
2. Agreeing on Exchange Rate Regimes: The mechanisms through which exchange rates are fixed.
3. The most debated and variable factor is the flexible exchange rate.

Principles of the International Monetary System

• The IMS comes into existence when moving from bilateral economic relations to a multilateral structure, capable of agreements or impositions.
• Before the current U.S. dollar, few currencies have come close to achieving this goal.
• Major changes were clearly manifested in 1870, extending the idea that it is essential to have rules for the valuation of different currencies.