Purchasing Power Parity
Purchasing power parity (PPP) is an important and recurrent concept in international finance. 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 be depreciated in order to return to PPP. Several theories of the balance of payments; and of the exchange rate deploy it in one way or an other. The theory of purchasing power parity envisages that the same goods or a package of products should sell for the same price in different countries when measured in a common currency. This concept may be expressed as:
where, P and P* stand respectively for the domestic and foreign prices or price indices and S denotes the rate of exchange in a given period. The purchasing power parity has been used as a theory of the price level. 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 ex pressed 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/1USD. 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 attained the same differential price level. Prices used in the calculation are market prices. i.e., the prices effectively paid by the consumers, and so they include all taxes which affect the final prices paid for products.
The foreign prices will determine the domestic prices when the exchange rate is fixed and the size of the domestic market is small. Alternatively, the theory of PPP is also applied widely as a determinant of the exchange rate. This application may be expressed as:
A change in the nominal exchange rate may not give a complete picture of relative changes in the international competitiveness of a country. If the rate of depreciation of the nominal currency of a country is less than the rate of increase in the relative price level of another country, the international competitiveness of the country could be declining despite depreciation of the nominal exchange rate. The real exchange rate (Q) may be defined as the rate of nominal exchange rate weighted by the relative price level. This concept may be expressed as:
Q = S(P*/P)
Hence, if the rate of inflation is faster in the home country, the nominal exchange rate should rise to stabilize the real exchange rate. The fall in the real exchange rate is an appreciation that reduces the international competitiveness, while conversely the rise in the real exchange rate helps in increasing the international competitiveness of the home country.
However, the PPP does not determine the exchange rates in the short run. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behavior of exchange rates. Purchasing Power Parities are currency conversion rates that both convert to a common currency and equalize the purchasing power of different currencies.
In other words, they eliminate the differences in price levels between countries in the process of conversion. PPPs are key statistical tools for international volume comparisons. However. there is a lack of understanding of the methodology and also of how and when PPPs should be used. The major use of PPPs is a first step in making inter country comparisons in real terms of gross domestic product (GDP) and its component expenditures. GDP is the aggregate used most frequently to represent the economic size of countries and, on a per capita basis, the economic well-being of their residents.
Calculating PPP is the first step in the process of converting the level of GDP and its major aggregates, expressed in national currencies, into a common currency to enable these comparisons to be made. The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by GDP. It includes consumer goods and services, government services. equipment goods and construction projects.
More specifically. consumer items include food, beverages, tobacco, clothing. footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishing, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, goods and services for personal care and household operation, repair and maintenance services.
Purchasing power parity is calculated under the joint Organization for Economic Co-opeartion and Development (OECD) Eurostat Program, the OECD and Eurostat share the responsibility for calculating PPP’s. Broadly, Eurostat handles the calculations for the European Union (EU) countries and for the EU ‘Candidate countries’ ( those countries which have applied for admission to the EU).