Finance

What Is Purchasing Power Parity

PURCHASING POWER PARITY:

Purchasing Power Parity is one of the common metrics of macroeconomic analysis to compare economic growth and living standards between countries. The “ Purchasing Power Parity” is a term used to explain the economic theory that states that the exchange rate of 2 currencies will be in equilibrium or at par. This means that the exchange rate between two countries should equal the ratio of the two country’s price level of a fixed basket of goods and services.

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EXPLANATION OF LAW OF ONE PRICE:

There are various versions of Purchasing Power Parity. The foundation for all those versions is the law of one price. According to the law of one price, identical goods should trade at the same price across countries when valued in terms of a common currency. The law of one price asserts that the foreign price of good X should equal the exchange rate adjusted of the identical goods in the domestic country.
FOR EXAMPLE, for an AUD based consumer, if the price of good X in the Australian area is AUD 100 and the nominal exchange rate stands at 1.40 USD / AUD, then the price of good X in the United States should be equal to USD 140.

THREE VERSIONS WHICH CAN BE DERIVED FROM THE LAW OF ONE PRICE ARE:

  • ABSOLUTE FORM OF PPP: The absolute version of PPP simply extends the law of one price to the broad range of goods and services that are consumed in different countries. If we ignore transportation costs and trade barriers, the price of the commodity throughout the world would be the same in order to prevent commodity arbitrage. For example, if a commodity is priced at $ 100 in the United States and RS 7000 in India, so, $100= RS 7000
    $ 1 = ₹ 70
    Thus exchange rate (INDIA/US ) = price of India/ price of US
    Of course, instead of doing it single commodity wise, we may consider a common consumption basket.
    Exchange rate (India/Us) = Basket price in India / Basket price in the US
    Obviously, this form of PPP does not at all hold good as we cannot ignore transportation costs and trade barriers, and also common consumption basket does not exist.
  • RELATIVE VERSION OF PPP: The relative version of PPP implies the exchange rate changes to offset changes in competitiveness arising from inflation differentials.
    For Example, if the foreign inflation rate is assumed to be 9% while the domestic inflation rate is assumed to be 5% then the exchange rate for ( domestic/ foreign ) must rise by 4% in order to maintain the relative competitiveness of the two regions. This means that whichever country had lower inflation, the currency of that country ought to have appreciated by an amount approximately equal to the difference in inflation.
  • EX-ANTE VERSION OR EXPECTATION FORM OF PPP: The ex-ante version of PPP asserts that the expected changes in the spot exchange rate are entirely driven by expected differences in national inflation rates. It is the relative form of PPP. It is majorly used for forecasting exchange rates in the future.

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USES OF PPP: Purchasing Power Parity are mainly useful for the following purpose:

  • Conversion: PPP exchange rate helps to cost but excludes profits and does not consider the different quality of goods among countries. The same product can have different types of quality or taxes or transport costs.
  • Exchange Rate Predictions: They are also used for predicting the exchange rate because the market exchange rate tends to move in the same direction over a period of time. PPP is assumed to hold either in the long run or more strongly in the short run.

 

Author: Bhagyashree Chandak

About the Author:
I aspire to become a research analyst and earn and use the best of my knowledge.

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