Purchasing Power Parity (PPP) is an economic theory that compares different countries’ currencies through a “basket of goods” approach. It is used to determine the relative value of currencies, economic productivity, and living standards between nations by accounting for cost of living adjustments. The theory posits that in the long run, exchange rates should move towards a rate that would equalize the prices of an identical basket of goods and services in any two countries.
The Basics of Purchasing Power Parity
Definition and Formula
Purchasing Power Parity is defined as the exchange rate between two countries that equates the purchasing power of different currencies in terms of the same basket of goods and services. The fundamental formula for PPP (absolute version) is expressed as:
where:
- \(\text{S}\) is the exchange rate between country 1 and country 2.
- \(\text{P}_1\) is the price level of a basket of goods in country 1.
- \(\text{P}_2\) is the price level of the same basket of goods in country 2.
Absolute vs. Relative PPP
Absolute PPP
Absolute PPP suggests that the exchange rate between two countries will be equal to the ratio of price levels of a fixed basket of goods and services in those countries. This theory works under the assumption that there are no transportation costs and no differential taxes applied to the goods.
Relative PPP
Relative PPP, on the other hand, takes into account changes in price levels over time. It states that the rate of change in the exchange rate between two currencies over a period should be equal to the difference in inflation rates between the two countries. The relative version is more practical as it accommodates the impact of inflation and other economic factors.
The formula for Relative PPP is:
where:
- \(\text{E}_{t+1}\) and \(\text{E}_t\) are future and current exchange rates respectively.
- \(\text{i}_1\) and \(\text{i}_2\) are the inflation rates in country 1 and country 2 respectively.
Special Considerations
Market Arbitrage and Law of One Price
PPP is closely related to the concept of arbitrage and the Law of One Price, which states that identical goods should sell for the same price, when expressed in a common currency, in different markets. However, real-world deviations such as transportation costs, tariffs, and market inefficiencies can affect these principles.
Balassa-Samuelson Effect
A well-known limitation of PPP is the Balassa-Samuelson effect, which suggests that countries with higher productivity growth will experience higher wage growth, leading to higher prices in non-tradable sectors (like services). This can cause the real exchange rate to deviate from PPP predictions.
Historical Context and Applicability
Historical Development
PPP was initially introduced by Swedish economist Gustav Cassel in the early 20th century. It became particularly relevant during the interwar period as countries sought methods to stabilize exchange rates after abandoning the gold standard.
Modern Use Cases
PPP is widely used today by international institutions such as the World Bank and the International Monetary Fund (IMF) to compare economic productivity and standards of living. It’s integral for compiling the Penn World Table, which provides a consistent measure of output across countries.
Examples
Big Mac Index
One popular example of PPP in practice is The Economist’s Big Mac Index. This informal measure compares the price of a McDonald’s Big Mac burger in various countries to gauge whether currencies are under or overvalued relative to the U.S. dollar.
Real-World Application
For instance, if a basket of goods costs $100 in the U.S. and an equivalent basket costs 800 RMB in China, the PPP exchange rate would be:
If the actual exchange rate deviates significantly, it suggests that the currency might be undervalued or overvalued according to PPP.
Related Terms
- Terms of Trade (TOT): Refers to the ratio of a country’s export prices to its import prices. Unlike PPP, TOT focuses on the exchange between countries’ export and import goods rather than the internal purchasing power.
- Exchange Rate: The value of one currency for the purpose of conversion to another.
- Inflation Rate: The rate at which the general level of prices for goods and services rises, eroding purchasing power.
FAQs
How reliable is PPP as an economic indicator?
Why is there often a discrepancy between actual exchange rates and PPP?
How is PPP used in calculating GDP?
References
- Cassel, Gustav. “The Theory of Social Economy.” 1921.
- “The Big Mac Index.” The Economist.
- World Bank, International Comparison Program (ICP).
- International Monetary Fund (IMF), World Economic Outlook.
Summary
Purchasing Power Parity (PPP) is a foundational economic theory that facilitates the comparison of economic productivity and standards of living across countries by using a common basket of goods. By accounting for cost of living differences, it helps determine relative currency values over the long term. While there are limitations and external factors influencing its accuracy, PPP remains a critical tool for economic analysis and policy-making.
