Purchasing Power Parity,
and the "Law of One Price"
The purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920. It is the method of using the long-run equilibrium exchange rate of two currencies to equalize the currencies' purchasing power. It is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price.
One popular version of the PPP is the Big Mac Index as published by the economist magazine. It relates the price of a Big Mac around the world as a means of comparing relative prices in different places.
Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries' relative inflation rates and the change in the exchange rate of their currencies.
A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.
Market exchange rates fluctuate widely, but many believe that PPP exchange rates reflect the long run equilibrium value. The distortions caused by using market rates are accentuated because prices of non-traded goods and services are usually lower in poorer economies. For example, a U.S. dollar exchanged and spent in the People's Republic of China will buy much more than a dollar spent in the United States.
The differences between PPP and market exchange rates can be significant. For example, the World Bank's World Development Indicators 2005 estimates that one United States dollar is equivalent to approximately 1.8 Chinese yuan by purchasing power parity in 2003. However, based on nominal exchange rates, one U.S. dollar is currently equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.
Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.
When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
Example:
If Mexico inflation is 6%, and US inflation is 4% (expected over the next year), and if the current spot exchange rate is M$11 / $1 USD, then the expected (in the future) spot exchange rate in one year would be = M$11 / USD * [(1+.06) MX / ( 1+.04) US] = M$11.21, which is a depreciation of the MX peso.
See also
- depreciation ... If the home country has higher inflation, then their currency should deprec...
- foreign currency trading ...The purchasing power parity (PPP) theory was developed by Gustav Cassel in 19...
- macro economics ...- PPP will have to fall to adjust, rather than FX ...
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