Thursday, 28 April 2011

The concept of "Purchasing Power Parity"

Purchasing Power Parity (PPP) is a theory of long-term equilibrium exchange rates based on the relative price levels in two countries. In other words, it shows the difference in actual value of a currency in terms of what you can buy with it. PPP is measured by taking the price of a basket of goods in one country and comparing it with the price of the same basket in another country.

It would be assumed that the nominal exchange rate and PPP would be relatively similar. However, we can normally see a marked difference in PPP-adjusted exchange rates compared to nominal rates. India, for example, has a GDP per capita of $1,100 if we are using the nominal exchange rate, however when the figures are PPP adjusted, the GDP per capita is closer to $3,000.

PPP figures are based on the "law of one price" which assumes that something costs the same amount wherever you go. If we take a Big Mac in France and a Big Mac in England, it is assumed that relatively they should cost the same amount, and then we can compare them directly to get PPP adjusted exchange rates between England and France. If Big Macs are just genuinely cheaper in France, this can skew the results as it means the law of one price does not apply. It has been said, however, that because PPP measures are made using a large "basket" of goods, that even where the law of one price does not apply, the results shouldn't be affected too much and this is normally not a worry.

A further problem to measuring PPP is the fact that some products are simply not available in certain countries, and they therefore cannot be used for comparison. Therefore as a general rule, countries with similar economic structures and similar trends of consumption tend to have more accurate PPP-adjusted exchange rate figures. Similarly, in some (mainly poor or developing) countries any statistics can be rather difficult to attain as the government records are not necessarily sound.

3 comments:

  1. "If we take a Big Mac in France and a Big Mac in England, it is assumed that relatively they should cost the same amount, and then we can compare them directly to get PPP adjusted exchange rates between England and France."

    Why should they cost the same amount?
    Relative to what?

    Why no mention of the GEKS-Fisher, Geary-Khamis, IDB, and the superlative method?

    What about differences in price level measurement?

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  2. They should cost the same amount because they're the same thing. Relative to eachother.

    The Geary-Khamis dollar is another name for the international dollar, and is a fictional currency that reflects the value of the dollar at a specific point in time. The years 1990 and 2000 are often used as benchmarks for the Geary-Khamis dollar.
    The others are methods of measuring PPP.

    It can be difficult for countries to compare accurately their PPP-adjusted exchange rate, and I outlined a number of the difficulties in my final paragraph, but it could be added that differences in price level measurement would lead to further difficulties in measuring PPP.

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