The European Union displays staggering differences between regions’ economies. For example, “per capita GDP in the City of London is 334% of the EU average–more than a dozen times greater than per capita GDP in north western Bulgaria, which is just 26% of the EU average” (presseurop.eu, 2010). Domestic disparities are also a major concern, in Germany for example; “a huge disparity emerges if we compare the city of Chemnitz in Saxony, where per capita GDP is 82% of the European average, and Hamburg, where it’s more than twice as high, at 192%” (presseurop.eu, 2010). Surprisingly, some poorer regions of Germany are on par with areas of Estonia in terms of GDP and employment rates. Furthermore, we can only expect divergences to get worse as the EU continues to widen. Widening has already increased disparities within the EU in social, territorial and economic terms significantly. Indicative of this are Bulgaria and Romania, the two most recent entries into the EU which currently “occupy the last two places in the European Union with 41 and 45 per cent of average EU GDP” (BalkanInsight.com, 2010). Even though Mingardi (2010: 14) believes that, “increased liberalisation”, in the form of the widening of the EU, “will allow better division of labour, more efficiently located labour and therefore lower prices for producers and consumers”, at present, widening of the EU has only increased disparities substantially.
The examples discussed reveal the astonishing divergences between European regions and give an idea into the extent of the problem. To tackle the aforementioned regional differences; the EU uses cohesion policy. The main aim of cohesion policy is to diminish economic well-being gaps between less favoured regions and more affluent ones. Policy makers agree this is a key concern continue to commit to tackle it with increases in the 2007-2013 budgets for cohesion policy by “3.2% to reach over â‚¬42.5bn P.A” (ec.europe.eu, 2010). Nevertheless, in spite of the budgetary increases for cohesion policy, regional disparities continue to grow within the EU and billionaire expenditures are yet to show real progress in addressing and realigning regional divergences. In fact, “a number of studies have demonstrated that inter-regional disparities have grown since the 1980s” (Esteban 2000; cited in Farole, T 2009: 3)
To understand why there are regional disparities, we must address the fundamental question of why certain regions’ growth is higher than others. A range of economic growth theories attempt to explain the growth of economies and thus the causes of regional disparities. These growth theories are split into two schools of thought; convergence and divergence school. However, it is widely accepted that these theories have their flaws and there isn’t one theory alone that can be used to explain economic growth and the cause of regional disparities single handily.
The convergence school, led by Solow’s Neo-Classical Growth theory (1956), is considered one of the major theories used to explain economic growth. The fundamentals of the theory state that per capita incomes of different regions converge in the long run due to diminishing returns to scale of labour productivity. It assumes a steady economic growth rate is achieved through varying the ratios of each of the inputs; capital, labour and technology. Through this method, an equilibrium state is achieved that is optimal for economic growth. Investment is translated into input of capital per worker and as this rises, returns steadily decrease and constant or decreasing returns to scale are realised leading to a decline in the marginal product of capital and an automatic dispersion of per capita income across regions. Thus, the theory states that gradual convergence in economies will occur.
The convergence school and neo classical theory has some, if narrow, support from growth figures within the EU. In particular, the growth that has been present in such countries as Greece, Spain, Ireland and Portugal in the period 1994 – 2006 supports convergence. From the European Union’s Fourth Cohesion Report (2007: 5) we can see that “Greece reduced the gap with the rest of EU-27, moving from 74% to reach 88% of the EU-27 average in 2005. By the same year, Spain and Ireland had moved from 91% and 102%, respectively, to reach 102% and 145% of the Union average”. However, “in spite of this progress, absolute disparities remain large” and contrary to these results, there is generally a very limited amount of support available for the convergence school. Although support is limited, the focus on convergence is understandable given that it is the basis of what the EU aims to achieve with the cohesion policy.
Convergence school, led by the Neo-Classical theory is flawed by its failure to take into account key mechanisms for economic growth. Factors such as; entrepreneurship, institutions facilitating economic growth and geographical differences are ignored. Although Solow’s model provides a strong base to explain economic growth, it has various downfalls and the “conclusions of Solow model were not fully proven by long-term world economic development” (Nedomlelova, 2007: 3). It is unrealistic to expect regional disparities to be completely diminished as convergence school suggests, therefore, cohesion policy has and will always play a key role within the EU’s policies.
The opposing divergence school of thought consists of many theories but has strong basis from Myrdal’s theory of cumulative causation (1957). Myrdal claims growth is spatially selective and that a cumulative “virtuous cycle” exists in developed countries and a “vicious cycle” in underdeveloped countries which, through a spiral effect, increases disparities. Myrdal emphasised the essential need for the “welfare world”, which today can be seen as the EU’s Cohesion Policy. The divergence school has several supporting theories including; core-periphery model, institutionalist theories, the endogenous growth model and new economic geography model.
Endogenous growth theory proposes that growth is a result of the regions’ available resources, more specifically, human capital and innovation. Opposing the convergence school, endogenous theory assumes that there will be increasing returns to knowledge and this will drive economic growth. Therefore, the more human capital a society has accumulated, the higher the productivity of each single member will be which increases the regions’ productivity and enables further economic advancements. Paul Romer (1986: 1003), an endogenous theory expert, dismisses the Neo-Classical assumption that countries eventually converge asserting that “the level of per capita output in different countries need not converge; growth may be persistently slower in less developed countries”. This theory has strong application in today’s global economy which displays an ever present and ongoing shift from a resource based economy to a knowledge based economy and in particular, ever increasing economic growth for those areas fostering knowledge based economies. Within the EU, support for this theory can be seen through the relative contrasts when comparing Regional Expenditure in R
Purchasing Power Parity Theory And Discuss Its Applicability Economics Essay
Purchasing Power Parity theory (PPP) is a basis for economic comparison. However, can this really be true for any product at any time? Is purchasing power parity (PPP) only valid in the long run, or is it also applicable in the short run, and what about the nature of the products, i.e. tradable and non-tradable goods? Which limitations are there to PPP?
Purchasing power parity tries to explain why the real exchange rate between currencies is what it is. It is based on the “law of one price” which states that in different markets, identical goods should have the same price. For goods which are easily traded, such as steel and iron, prices should be identical within relevant range. The reason for this is that if £100 could get you 10kg of iron in the domestic UK market, or 5kg in the foreign German market, one would expect people to buy iron in the UK and sell it in Germany for a profit, taken into consideration that shipping costs are negligible, and that the iron is of equivalent quality. Demand for UK iron would rise and demand for German iron would fall. In the long run this would result in prices for domestic UK iron to rise and for foreign German iron to fall. The equilibrium here would be that £100 could buy you 7.5kg of UK iron, or 7.5kg German iron.
As the currency used in the UK and Germany is different we need to know how many British pound we need in order to buy one Euro. If you need £15 to get a haircut in the UK and you need â‚¬10,50 to buy the same quantity (one haircut) in Germany, then the real exchange rate would be £1.43 per â‚¬ found by the formula:
which equals .
This strength/purchasing power of one currency over another should be equal in the long run. Hence the name purchasing power parity. Rogoff argues that the difference between the actual currency exchange rate and the PPP exchange rate is..
PPP is only a theory as it cannot be proven to be correct, but until it is not disproved it is seen as a valid assumption. It is considered to be valid in the long run and not the short run, as people take time to realise and exploit profitable differences in markets which eventually leads to a long run market equilibrium. Michaely (1982) argues that the PPP, which originally came from Gustav Cassel, is “indeed a monetary approach analysis; namely that it assigns the determination of the foreign-exchange rate to the money market alone, without allowing an explanatory role to the goods market and to goods prices.”
As the real exchange rates are affected by tradable goods as well as by services, different interest rates, speculators and investment, it is not the best method to compare the purchasing power of different currencies. Comparing GDP (gross domestic product) can be done if PPP is used to compare currencies on the bases on a basket of goods.
We can differentiate goods and services in a basket of goods into two categories: tradable goods and non tradable/domestic goods. This is decided upon how easily transported/traded a good is as well as government policies such as bans, tariffs and quotas imposed on them. Tradable goods, (commodities) which are of equal quality no matter where they are produced, will be traded at a value close to the market exchange rate. Generally, any good that is easily transported belongs into this category. Highly tradable goods are raw materials such as gold, petrol, gas, oil and diamonds which have a high value. Non tradable goods that are produced and used by domestic consumers such as hairdressers, taxi costs, house rent, and books are hard to get exported, and as foreign people are unlikely to find a hairdresser whose price can compensate the costs of travelling, or move houses just because it is cheaper than the current one, the non tradable goods will be closer to the PPP exchange rate rather than the actual market exchange rate.
Whether a good is tradable or non-tradable does not only depend on how easily it can be transported. Books may be cheap in Germany and are easily transported, yet there is little demand in the UK for German books, as they are written in a different language. The same can be said about packaged food and laptops for certain countries that have different letters in their alphabet. Their PPP may be further away from the real exchange rate, as they would behave like non tradable goods.
There are exceptions to this rule, such as expensive surgeries or medical care which is often much cheaper in east Europe than in west Europe. But are these of equal quality? The difference in price is due to different qualifications, less equipment and less experience. Eventually, in the long run, we would expect prices of east European doctors to rise, but there will still be a large enough price difference which is due to travel and quality difference.
As PPP is based on a basket of goods and services, this already excludes ones that are not recorded. Many of these goods are not tradable, and hence are affected by the income level of these countries. However, there are goods in foreign countries that are purposely priced under international market price, in order to get a market share. For example, the German car manufacture Volkswagen produces cars in Germany and sells them in Poland for less than in Germany. Volkswagen does this because people in Poland earn less than in Germany, and they want to get a large market share. Some of these cars get re-imported into Germany to be sold under the domestic price. As Volkswagen cannot increase its price in Poland without losing customers and market share, car dealers in Germany will need to lower their prices in order to eventually get to equilibrium.
Besides the obvious limitation to PPP that products are not always homogeneous, there is also the problem with “apparent” quality difference. A Product manufactured in England might be seen as of superior quality to the exact same product manufactured in China. Both products, even though they are equal, would have different equilibrium prices.
PPP does not work in the short run, as people take time to take notice of opportunities to exploit differences in prices. It is only valid for highly tradable and valuable goods such as diamonds and gold, as these prices. Antweiler says that short run exchange rate movements are influenced by the news, such as “announcements about interest rate changes, changes in the perception of the growth path of economic”(2009).
Pappell (1997) discusses that the difference between PPP and the real exchange rate can also depend on which country’s currency we base it on. This can happen because of regime changes or because governments are artificially interfering with the exchange rate in order to increase growth. Generally, the lower the income level of an economy is, the further away the PPP is from the real exchange rate, and the more an economy develops, the closer the PPP will be (RIETI 2003). An example of this would be China and its domestic currency “Yuan” whose exchange rate does not reflect the actual purchasing power of other currencies. This way they increase exports and have huge economic growth. With a common currency for multiple countries such as the Euro, it is easier to compare prices, as no calculations have to be made. The purchasing power of the euro is different across different Euro-countries (destatis, 2009).
In theory, purchasing power parity theory is valid, yet it’s application has many limitations. It is an accurate explanation of why exchange rates change, but only for a certain basket of goods. Raw materials such as metals, diamonds and wood are easily traded and an international market equilibrium can be found fast. These goods are traded close to the real exchange rate. Non tradable goods such as packaged food are hard to trade and will be closer to the PPP exchange rate. Whether goods are of equal quality makes is a strong limitation to whether the chosen goods can really be compared. PPP is only a valid theory in the long run, as people take time to have to recognise and exploit the price differences. With a common currency across multiple countries such as the Euro, this reduces this greatly. Lastly government intervention with regulations, import taxes and tariffs affect the PPP as it makes buying foreign products more expensive.