What is purchasing power parity?

Purchasing power parity is based on the assumption that in absence of duties, transaction costs and other curbs, identical goods should have the same price in different countries when expressed in same currency. In other words, how much money would be needed to purchase same amount of goods and services in two different markets. This allows for calculating PPP exchange rates that can be used to convert gross national income of countries in terms of a single currency, usually the US dollar, to facilitate meaningful comparisons after adjusting for prices. How does the concept work? A good example of the PPP concept is the 'Big Mac' index compiled by the Economist. It assumes that over the long-term McDonald's Big Mac burger should have same price across the world. Comparing the rupee price of this burger with the price in the US gives the Rs-$ exchange rate on PPP basis. It is then possible to compare this PPP exchange rate with market rate and say if the rupee is undervalued or overvalued. How does India beat Japan in PPP terms? Under the regular method of GDP calculation, India's economy is well behind Japan. Even assuming an average economic growth rate of 7.5% over the next five years, the Indian economy will be only $2.9 trillion compared with Japan's $6.69 trillion. However, price levels in Japan is much higher than that of India or in the US.

When the International Monetary Fund adjusts the national income of the two countries in terms of PPP exchange rates using US dollar, Indian economy grows to $4.46 trillion in 2011 because of lower prices while Japan stays at $4.44 trillion. Essentially, it means that in total two countries have the same purchasing power, but because of its much lower population average Japanese is way ahead of average Indian in purchasing power. What is the relevance of PPP? The concept of PPP is useful in comparing quality or standard of living in different countries which may not be possible if one just looked at per capita income. A lower income may allow a good quality of life in a country of prices are low. For instance, a haircut may cost lot more in London than in Delhi. The major shortcoming of PPP exchange rates is that these are difficult to measure.

Purchasing-power parity theory. A theory which states that the exchange rate between one currencyand another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account. To see why, we'll use an example. Purchasing Power Parity and Baseball Bats First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in Mexico, so consumers are much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to see three things happen: 1. American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw in "A Beginner's Guide to Exchange Rates" this will cause the Mexican Peso to become more valuable relative to the U.S. Dollar. 2. The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down. 3. The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up. Eventually these three factors should cause the exchange rates and the prices in the two countries to change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8 MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off. Purchasing Power Parity and the Long Run Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so. You might think that my example of consumers crossing the border to buy baseball bats is unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or thousands of the bats in Mexico then shipping them to the United States for sale. It is also not unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United States and Mexico is not sustainable because an individual or company will be able to gain an arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other market (This is explained in greater detail in What is Arbitrage? ). Since the price for any one good should be equal across markets, the price for any combination or basket of goods should be equalized. That's the theory, but it doesn't always work in practice.

Law of one price

Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.[3]

The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent.

Purchasing power parity

From Wikipedia, the free encyclopedia

GDP per capita adjusted for purchasing power parity (PPP) in the world, 2007

Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange ratebetween countries in order for the exchange to be equivalent to (or on par with) each currency'spurchasing power. It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries. Among other uses, PPP rates facilitate international comparisons of income, as market exchange rates are often volatile, are affected by political and financial factors that do not lead to immediate changes in income and tend to systematically understate the standard of living in poor countries, due to theBalassaSamuelson effect.

Purchasing Power Parity

What is Purchasing Power Parity? Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barri

Relative purchasing power parity

From Wikipedia, the free encyclopedia

Relative purchasing power parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute PPP theory. [1]
Contents [hide]

1 Explanation 2 Absolute purchasing power parity 3 See also 4 Notes

[edit]Explanation Suppose that the currency of Country A is called the A$ (A-dollar) and the currency of country B is called the B$. The theory states that if the price P in country A of a basket of commodities and services is P A-dollars, then the price Q of the same basket in country B will be CP A-dollars, where C is a constant which does not vary over time, or, equivalently, CPS B-dollars, where S is the (variable) number of B-dollars required to buy one A-dollar, i.e. the exchange rate. If (1) and (2) denote two different dates, then it follows that

and hence

or, in words, the factor representing the movement in market exchange rates is equal to the ratio of the inflation factors (changes in price levels) of the two countries (as one would intuitively expect). Absolute purchasing power parity occurs when C=1, and is a special case of the above. According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the EUR should appreciate by approximately 2%

compared to the purchasing power of the USD (equivalently the USD will depreciate by about 2%). Note that it is incorrect to do the calculation by subtracting these percentages one must use the above formula, giving = 0.98058, i.e. a 1.942% depreciation of the USD. With larger price

rises, the difference between the incorrect and the correct formula becomes larger.[2] [edit]Absolute

purchasing power parity

Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing powers to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries (such as gold, assuming this is freely transferable) but is likely to be false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.