5 - Parity

Summary

Concept of parity

Parity between two currencies is a hypothetical exchange rate involving equivalence in value. So parity is also called exchange-rate parity. Parity is not the actual exchange rate (except by accident), nor it is even a central tendency of exchange-rate values. Rather, it is an exchange-rate norm.

Four uses of parity can be distinguished. First, parity is a frame of reference from which to assess the level of the exchange rate. Second, parity appropriately defined is an exchange rate about which and by means of which “specie points” (bounds to the exchange rate outside of which arbitrage opportunities exist) are constructed. Third, expressing the exchange rate as the percentage deviation from parity (or, equivalently, as an index number with parity as the base) makes it easier to follow the movement of the exchange rate over time and enhances interpretation. Fourth, parity provides an invariant exchange-rate standard and therefore is of practical use in contracts and in courts of law (Nussbaum, 1950, p. 333).

There are two types of parity, metallic and legal, each with subcategories. The metallic (also called “mint”) parity is the relative pure-specie content of the two countries' currencies or, equivalently, the ratio of the countries' mint prices expressed in common fineness. The mint price, it may be recalled, is the value of domestic money that the country's authority would coin per ounce of gold deposited with it.