Analysis Of USD/AUD Exchange Rate Movement And Forecasting Using Relative Purchasing Power Parity Method

Part A: Exchange Rate Movement Between USD/AUD

Exchange rate is an essential Part for an economy to function as it allows a country continue trading and conduct international transactions with different Parts of the world. Exchange rates determines the price of unit of currency in terms of another unit of currency. The exchange rate movements depend upon the type of exchange rate regime followed by the Particular country like floating exchange rate regime and fixed exchange rate regime. The purpose of this report is to understand and analyze the movement in exchange rates between two countries. The USD/AUD exchange rate was chosen for the purpose of analysis and the exchange rate movement between 1^st January 2019 to 31^st December 2019 was analyzed and discussed about in the first Part of the report. There are multiple methods which are utilized in the financial world to forecast exchange rates like covered interest rate parity, uncovered interest rate parity, purchasing power parity and many others. The USD/AUD exchange rate was forecasted using the Relative Purchasing Power Parity method for the period starting from the first quarter of 2015 till first quarter of 2021. The forecasted exchange rates were then compared with the realized exchange rate with discussing the benefits and drawbacks of relative purchasing power parity method in forecasting exchange rates.

USD/AUD is the fourth largest traded currency in the world but it does not constitute the US dollar index. In the exchange rate, Australian Dollar is the quote currency and US dollars is considered as the base currency. The exchange rate is influenced by multiple factors related to Australian and United States economy. The exchange rate movement between the two countries from 1^st January 2019 to 31^st December 2019 is presented in the graph below:

The AUD/USD exchange rate has witnessed a downward trend since the beginning of 2019 where the rate went on to fall to the levels of 1.38 till the mid of February 2019. The exchange rate showed a slight recovery where the US dollars appreciated in value reaching to the levels of 1.4534 in the month of June 2019. The US dollar went on to appreciate compared to the Australian dollar reaching to the height of 1.49 in the month of August 2019. Till the end of December 2019, the US dollars have depreciated to the levels of 1.42 compared to Australian dollar.

The relative purchasing power parity is a forecasting tool that is utilized by the financial world and it advocates that a country’s rate of inflation and the value of its foreign exchange rates ought to be equal over time, and that price divergence between products and services in two nations should equalize owing to currency rate appreciation or depreciation (Arize, Malindretos and Ghosh 2015). To assess the effectiveness of the relative purchasing power parity forecasting method, AUD/USD quarterly exchange rates data from the first quarter of 2015 till the first quarter of 2021 has been collected which is to be employed in the forecasting model to get the expected exchange rates based on the inflation differential between two countries. Quarterly inflation data for Australia and United States has been collected for the same period to analyse the impact of inflation on the exchange rates between two countries.

Part B: Forecasting Using Relative Purchasing Power Parity method

According to relative purchasing power parity conditions, if inflation in a country is higher than inflation in the reference country, the inflation differential will have an impact on the exchange rate between the countries, and the exchange rate of the country with higher inflation will depreciate in future periods compared to the other country (Bahmani-Oskooee, Chang and Lee 2016). Following the concept, the inflation differential between Australia and United States have been ascertained using the following formula:

Where, S₀ represents the spot rate of the AUD/USD exchange rate

I_C representing the level of inflation in Australia

I_B representing the level of inflation in United States

The inflation differential was calculated employing the formula above and multiplied with the spot rate of AUD/USD exchange rate to get the expected exchange rate in the next quarter based on the relative purchasing power parity. The following chart depicts the comparison between realized value of exchange rates between the two countries and the forward exchange rates implied by the relative purchasing power parity concept:

When looking at the chart above, it can be observed that the realized purchasing power parity model has been a hit-or-miss situation, as it has correctly predicted exchange rates for a short period of time while also missing the mark in various sections of the analysis period. For the period starting from first quarter of 2015 till the first quarter of 2016 the exchange rate suggested by realized purchasing power parity has failed to predict the exchange rates underestimating the depreciation level of Australian dollar compared to US Dollars in the mid of 2015 and overestimating the depreciation in the Australian dollars as a result of high inflation in the Australian economy.

For an extended period of time starting from the first quarter of 2017 lasting till the mid of 2019, the model has been more or less accurate in predicting the exchange rate with the deviation being less than 5% for each quarter. Since the starting of 2020, the model has struggled to predict the exchange rate movement in the AUD/USD with the deviation of more than 15% per quarter. During the end of 2019, the model overvalued the Australian dollars depicting a significantly lower depreciation in the value of the Australian dollars compared to the US dollars. The reason for such deviations can be attributed to economic uncertainty prevailing at the time due to the onset of Covid-19 pandemic.

Part C: Purchasing Power Parity and Relative Purchasing Power Parity

Purchasing power parity is a model which is used to forecast exchange rates across nations and is referred to the differences between the price of a commodity which is similar in both nations and the exchange rates of the countries (Iyke and Odhiambo 2017). The theory of Purchasing Power Parity proposes that the exchange rate between two countries will remain at equilibrium or will be at the ratio of the purchasing power in the individual countries. For instance, If a burger costs $1 in the United States and 1 AUD in Australia. Then, according to the PPP, buying power in the United States and England is equal. The international exchange rate between the pound sterling and the dollar, according to the PPP, is 1 USD per 1 AUD or 1 AUD per 1 USD. As a result, the connection demonstrates that the currency exchange rate between two nations is always equal to the current price ratio between the two countries. This argues to the law of one price, which states that when Australian dollar is swapped for US dollars, a car will cost the same in Australia and US. As a result, the PPP indicates that nominal prices and nominal exchange rates between two nations have a link (Jiang, Bahmani-Oskooee and Chang 2015).

The Relative Purchasing Power Parity is a dynamic variant of PPP that compares variations in the inflation interest rates between two nations with adjustments in their exchange rates across the same timeframe (Munir and Kok 2015). Relative Purchasing Power Parity is a model that demonstrates the changes in the exchange rate between two countries with relation to change in the prices of the goods and commodities due to the effects of inflation in the countries involved. The effect of inflation is responsible for reducing the purchasing power of the currency where the high inflation environment is prevailing, as a result the exchange rate of the country with high inflation would be depreciated in the future (Güri? and T?ra?o?lu 2018).

For instance, in the example if due to inflation the prices of goods and services in the United States increases by 2 percent and at the same time the prices of goods and services in Australia increased by 4 percent. According to the concept of purchasing power parity, the exchange rate between Australia and United States would be expecting a change of around 2 percent and the Australian dollar would be expected to depreciate at a rate of around 2 percent per year. Alternative way to present the fact is that the US dollars are expected to appreciate by 2 percent per year against the Australian dollars. The above situation would result in reducing the real purchasing power of the Australian dollar by the amount of inflation it has faced (McKinnon and Ohno 2016).

There are occasions where the purchasing power parity cannot hold good and this is due to the inherent assumptions of the model in estimating the exchange rates. In the calculations of expected exchange rates in the first Part of the report, it was evident that the theory is not able to predict the movements in exchange rate efficiently. There are multiple limitations of the theory which makes the model unable to predict the movement in the exchange rates. The problems in the assumptions of the purchasing power parity are explained in detail below:

• The primary assumption of the theory is that price levels in a country brings about changes in the exchange rate of a country and the exchange rate does not play a role in determining the price levels of the country. According to research conducted empirically it was found that exchange rate is responsible for determining the price levels of the country along with the inflation level (Chand 2014).
• The PPP theory argues that there are almost no transaction costs and trade barriers between nations, based on the law of supply and demand. The premise of the theory is that the amount of tax rates levied on each market is also identical, which explains why there are no trade barriers and transaction costs. However, because we all know that trade barriers exist between nations and that tax rates vary, the theory’s assumptions are unjustified. Transportation expenses would lower the cost of commodities shipped in an exporting country, whereas the converse would occur in an importing country. The more the transactions cost and trade restrictions impose within countries, the more the prices of similar goods in different countries would differ (Callen 2022).
• There are many factors that goes behind in assisting in selling of a product which is considered while pricing a product in a Particular market. For instance, for a product sold in a food chain joint may include the cost of the rent of the space, in the price of the product. This cost of input may differ across regions and countries and hence the price of similar products tends to differ in different markets.
• The primary assumption of law of one price is that every individual has perfect information regarding the prices of products in different markets. The price information amongst the traders and individuals would drive the trading behavior amongst countries as they would import goods from countries with cheaper prices and export goods to countries with higher prices to gain advantage. This information is not easily available to individuals and traders as there are some aspects of the pricing that may be known to the investors the remaining would not be known to them (Economics key 2014). Even if a price advantage is recognized by the traders, the scalability which is required by them to exploit the price differences is not achievable. Hence, the law of one price fails to hold goods implying that the purchasing power parity also does not holds good.
• The competition level for a Particular product in a country is ignored in the assumptions of the Purchasing power parity theory. The demand for a product may be different in a country from another country due to the consumption behavior of the residents of the country. Hence, the price of the product is bound to be different in different countries. Furthermore, there are some countries which are not included in the basket of comparison countries. ICP is a program started by the World bank group to gather data related to various comparative parameters across the globe. The ICP does not include all the countries in the world while reporting the comparative prices of products to measure the purchasing power parity.
• The theory is specifically designed for countries which is involved into trading activities and not a country which is a banker and does not involve in huge amount of trading. Hence, the theory takes into consideration the current account transactions ignoring the transactions happening at the capital account of the country.
• Recent economic and political developments throughout the world have demonstrated that the currencies of several nations have experienced tremendous volatility, which the PPP theory is unable to explain. When the theory was applied to the calculations in Part one, it was discovered that it was unable to anticipate the size of change in exchange rate values, and in some cases, it even failed to address the shift in exchange rate direction. As a result, scholars and individuals all around the world have concluded that the PPP theory is not a perfect predictor of exchange rates. The buying power parity is a notion that is projected to be achieved over time with little to no impact on short-term exchange rate price changes.

After considering all of the aforementioned limitations as well as the practical calculations based on the previous five years’ exchange rate data, it can be concluded that the Purchasing Power Parity phenomenon, on which the Relative Purchasing Power Parity is based, is a reasonable explanation for long-term exchange rate changes. The theory also aims to explain the factors that influence balance of payments, demonstrating that trade behaviour and payments between nations are influenced by the relative price levels of the countries involved. As a result, exchange rates are affected by changes in a country’s pricing and price levels.

Conclusion

The purpose of the research was to examine the exchange rate movements of a currency pair, AUD/USD, for the period beginning January 1st, 2019 and ending December 31st, 2019. The currency pair’s daily price data was obtained, and the exchange rate’s movement was studied and explained in the report. Purchasing Power Parity is one of several ways for establishing or projecting an exchange rate between two nations (PPP). The research focuses on utilizing the Relative Purchasing Power Parity (RPPP), a dynamic form of the PPP theory, to predict the projected exchange rate based on RPPP using inflation data from Australia and the United States. Using the RPPP hypothesis, it was discovered that the realized exchange rate of the currency pair differed from the anticipated exchange rate. The report visually depicted the periods of similarity and disparity in expected and realized exchange rates. The final section of the study is devoted to discussing the PPP technique of exchange rate forecasting, including the equation and its components. The causes behind the RPPP theory’s inability to anticipate exchange rate changes in the AUD/USD currency pair, as seen in previous sections of the study, are explored and addressed in detail. It was determined that the PPP theory may be appropriate for predicting exchange rate in the longer term but it cannot be used to estimate the short-term movements in the exchange rate.

References

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Bahmani-Oskooee, M., Chang, T. and Lee, K.C., 2016. Purchasing power parity in emerging markets: A panel stationary test with both sharp and smooth breaks. Economic Systems, 40(3), pp.453-460.

Callen, T., 2022. Purchasing Power Parity: Weights Matter. [online] IMF.org. Available at: <https://www.imf.org/external/pubs/ft/fandd/basics/ppp.htm> [Accessed 29 March 2022].

Güri?, B. and T?ra?o?lu, M., 2018. The Validity of Purchasing Power Parity in the BRICS Countries. Prague Economic Papers.

Iyke, B.N. and Odhiambo, N.M., 2017. Foreign exchange markets and the purchasing power parity theory: Evidence from two Southern African countries. African Journal of Economic and Management Studies.

Jiang, C., Bahmani-Oskooee, M. and Chang, T., 2015. Revisiting purchasing power parity in OECD. Applied Economics, 47(40), pp.4323-4334.

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McKinnon, R.I. and Ohno, K., 2016. 7 Purchasing power parity as a monetary. The Future of the International Monetary System: Change, Coordination of Instability?, p.42.

Munir, Q. and Kok, S.C., 2015. Purchasing power parity of ASEAN-5 countries revisited: Heterogeneity, structural breaks and cross-sectional dependence. Global Economic Review, 44(1), pp.116-149.

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