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Can Anyone Explain The Discrepancy


Marina
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Something that has plagued me ever since I started thinking about things like money and economies is:

What is the basis for valuing a currency?

I have always believed that other things being equal you might make a simplistic comparison like:

A loaf of bread in England costs £1

A loaf of bread in France costs 10 Francs (forget the Euro for a minute)

Therefore £1 = 10 francs.

A man's labour in England costs £100

A man's labour in the USA costs $200

Therefore £1 = $2

Unless you have some sort of basis for comparison, how do you value another country's currency?

We are told stuff from China and India is cheap because labour is so cheap. To me this suggests there is some huge imbalance between our currency exchange rates.

Why should £1 buy 6 minutes of someones labour in this country but a day's labour somewhere else? Who decides what the exchange rate is between countries?

I know the answer is 'the market' but there must be some more solid comparison otherwise there could be huge imbalances.

Hold on, there are huge imbalances. Why? If we have such a skewed exchange rate it means other countries can compete with and put our businesses out of business. Surely if 'the market' cannot get an equitable exchange rate - you need import controls to protect your own manufacturing industries etc. Why is everyone so determined to have a 'free market' when, in a free market, our jobs are going to go abroad and we will have mass unemployment here.

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What is the basis for valuing a currency?

Well, the glib answer is "demand and supply".

http://en.wikipedia.org/wiki/Exchange_rate

The real exchange rate is the rate at which an organisation can trade goods and services of one country for those of another.
A loaf of bread in England costs £1

A loaf of bread in France costs 10 Francs (forget the Euro for a minute)

Therefore £1 = 10 francs.

Yes, this is known as purchasing power parity:

http://en.wikipedia.org/wiki/Purchasing_power_parity

PPP is a theoretical exchange rate derived from the perceived parity of purchasing power of a currency in relation to another currency. It takes into account that some goods like real estate, services (e.g. medical services) and heavy low-value items (gravel, grain) are not traded between nations, and thus not reflected in the exchange rate. In contrast to the "real" exchange rate that the currencies are traded for in the official market (as opposed to the black market), the PPP exchange rate is calculated from the relative value of a currency based on the amount of a "basket" of goods the currency will buy in its nation of usage. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy.

PPP equalization and the law of one price

The law of one price states that prices of traded goods will equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates.

The Economist operates a (tongue-in-cheek) purchasing power index by comparing the prices of a Big Mac in each of the countries surveyed:

http://www.economist.com/markets/Bigmac/Index.cfm

We are told stuff from China and India is cheap because labour is so cheap. To me this suggests there is some huge imbalance between our currency exchange rates.

There are many people who would agree with you (including the US and EU governments). Most economists believe that the rate at which the Chinese currency is pegged to the dollar is too weak and, given a free exchange rate regime, the yuan would strengthen. However, there are some economists who think that the yuan would actually weaken if China un-pegged it, as currently Chinese nationals are only allowed to hold yuan; if the exchange rate regime was liberalised, no doubt many would like to diversify their holdings into gold, dollars, euro, etc. But China's large trade surpluses with the rest of the world suggests that the yuan would strengthen given a floating exchange rate, although no-one can agree on how much it will strengthen.

Who decides what the exchange rate is between countries?

The market, or the government, in the case of economies where the exchange rate is fixed.

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by moving enormous amounts of money around to take advantage of discrepancies in interest rates between countries. Simplistic, I know. The actual method used to do cross-currency calc is quite meaty. For example, you can get an enormous return in a S.A. bank account now, but would you descibe it as 'risk free'? And will the continuing slide of the rand despite the high interest rates offered erode any potential gains?

Hence the reason why if the dollar breaks up another couple of cents vs the £ and holds it there for another month, UK rates will have to rise in order to bring it back. Nice for those of us with savings. Not so nice for people with debts.

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Well, the glib answer is "demand and supply".

http://en.wikipedia.org/wiki/Exchange_rate

Yes, this is known as purchasing power parity:

http://en.wikipedia.org/wiki/Purchasing_power_parity

The Economist operates a (tongue-in-cheek) purchasing power index by comparing the prices of a Big Mac in each of the countries surveyed:

http://www.economist.com/markets/Bigmac/Index.cfm

There are many people who would agree with you (including the US and EU governments). Most economists believe that the rate at which the Chinese currency is pegged to the dollar is too weak and, given a free exchange rate regime, the yuan would strengthen. However, there are some economists who think that the yuan would actually weaken if China un-pegged it, as currently Chinese nationals are only allowed to hold yuan; if the exchange rate regime was liberalised, no doubt many would like to diversify their holdings into gold, dollars, euro, etc. But China's large trade surpluses with the rest of the world suggests that the yuan would strengthen given a floating exchange rate, although no-one can agree on how much it will strengthen.

The market, or the government, in the case of economies where the exchange rate is fixed.

Thanks for your answer. I am still left pondering ....

Why doesn't the market correct the huge imbalances in purchasing power parity?

If it doesn't (and it hasn't) - surely import controls must be used?

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Why doesn't the market correct the huge imbalances in purchasing power parity?

If it doesn't (and it hasn't) - surely import controls must be used?

It is import controls that help maintain the imbalances in ppp, rather than solve them. It is why, for example, that european farmers do so well compared to their developing country competitors. By restricting imports, we keep European farmers rich and the world's poor poor.

Market theory again predicts that the imbalances in ppp will be reduced, but this will take time and not apply to goods and services that are not transferable or comparable. Local goods cannot be transferred, and I will not be able to pop over to India because I can buy a cheaper curry there than in London.

I may find that modern technology allows educated Indians to answer the phone or do IT work from India rather cheaper than from the UK, which will have the effect of lowering UK equivalent wages and increasing India - and so we move towards ppp.

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The reason that price disparities exist between national economies is a function of the state of basic economic infrastructure in the country concerned (in direct contravention of "free market" theory and the rest of the monetarist hogwash masquerading as economics these days).

In India, labor is cheap because there are no unions, healthcare, minimum wages and other restrictive regulatory laws to impede the cost of doing business.

In physical productive terms, producing goods in 3rd world countries is cheaper because the cost of building the economic infrastructure that was required to develop the component technology in the first place is not factored into the price.

By setting prices according to "free market" ideology, the global economy as a whole will tend to operate at below break even levels, with increasing disinvestment in essential basic infrastructure required to introduce net gains in economic product in the long term.

Corporations make short term monetary profits, but the global economy spirals into a long term physical economic collapse.

Properly considered, profit should be a metric of gain in productivity rather than an increase in monetary primitive accumulation.

Hence, valuation of national currencies becomes the relative measure of net physical productive output over monetary input.

i.e. An increasing currency is one that is growing in terms of physical productivity.

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