INTERNATIONAL FINANCIAL MANAGEMENT

The Test Of A Good Theory Is How Well It Stands Up In The Real World



The Test Of A Good Theory Is How Well It Stands Up In The Real World

SECTION 1: Introduction

“In theory, theory and practice are the same. In practice, they are not.” This quote from Albert Einstein is really interesting. It would imply that there is a kind of lens between theory and practice which would deform one when we translate it in the other(Gujarati, 2011, pp. 15-19). However, it is stated that we could evaluate the degree of validity of a theory by studying its ability of being confirmed in practice, that is to say by studying empirical evidences. In this management report, we will first take a closer look to the discussions about two main theories of International Finance:

The Purchasing Power Parity Theory (PPP)

The Interest Rate Parity Theory (IRPT)

International Fisher

Then, we will look for empirical evidences related to these theories. They will be of different nature and sources. The preferred source will be Primary Evidence but we will sometimes be forced to use secondary and even tertiary evidences to form our opinion. Finally, we will conclude by analyzing all the evidences found and try to assess the extent to which each stands up in practice(Cheung, 2010, pp l79-189 ).

The whole theories are really discussed by many different persons. Indeed, every theory has its own strengths and weaknesses. Moreover, the best way to assess a theory is to submit it to the real world.

Purchasing Power Parity

This theory is about the concept of evolution of the currencies. It assumes that the price for a same good should be the same all over the world. If we assume that, comparing the prices of a same good or basket worldwide (that is to say in different currencies), is supposed to give us a clue on a currency's future fluctuation (Hill, 2011, pp. 136-138). But this theory has been elaborated assuming that the market was perfect, that there were no transportation costs and no official barriers to trade. In other words and to be valid, the prices of a same good/basket of good should be the same in every country, and the only difference should be due to the fluctuations of the currency. The relevance of this theory is really discussed but today, we can say that the common finding of all the studies carried is that the PPP theory stands up in practice only on the long term. However, the position of the International Finance's specialists changed over the years. As an example, before the mid-70's the PPP theory was widely believed as long as studies using statistics showed that PPP and currencies fluctuations was very related. But in a second time, after the mid-70's, many studies proved the imperfection of such a theory and harmed the Purchasing Power Parity Theory's credibility. Indeed, statistics are sometimes useless with explaining specific phenomenon. Thus, Cumby, (2009) proved that there was a difference of PPP according ...