Purchasing Power Parity (PPP)

Student:
Elena Cristina BACIU,
ISE

The value of a currency expressed in terms of the amount of

goods or services that one unit of money can buy. Purchasing
power is important because, all else being equal, inflation
decreases the amount of goods or services you'd be able to
purchase.

Purchasing power is the number of goods or services that can

be purchased with a unit of currency.

To measure purchasing power, you'd compare against price index

such as CPI (consumer price index). A simple way to think about
purchasing power is to imagine if you made the same salary as
your grandfather. Clearly you could survive on much less a few
generations ago, however, because of inflation, you'd need a
greater salary just to maintain the same quality of living.

Purchasing
power (sometimes
retroactively
called adjusted for
inflation)

A component of some economic theories and a technique

used to determine the relative value of different currencies.

CONCEPT:
The concept of purchasing power parity allows one to
estimate what the exchange rate between two currencies
would have to be in order for the exchange to be on par
with the purchasing power of the two countries' currencies.
Using that PPP rate for hypothetical currency conversions, a
given amount of one currency thus has the same purchasing
power whether used directly to purchase a market basket of
goods or used to convert at the PPP rate to the other
currency and then purchase the market basket using that
currency. Observed deviations of the exchange rate from
purchasing power parity are measured by deviations of
the real exchange rate from its PPP value of 1.

In other words, the exchange rate adjusts so that an identical good

in two different countries has the same price when expressed in
the same currency.
For example, a chocolate bar that sells for C$1.50 in a Canadian
city should cost US$1.00 in a U.S. city when the exchange rate
between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate
bars cost US$1.00.)

Theories that invoke purchasing power parity assume that in some

circumstances it would cost exactly the same number of, say, US
dollars to buy euros and then to use the proceeds to buy a market
basket of goods as it would cost to use those dollars directly in
purchasing the market basket of goods.

The relative version of PPP is calculated as:

1
=
2
Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2

PPP exchange rates help to avoid misleading international

comparisons that can arise with the use of market exchange rates.

For example, suppose that two countries produce the same

physical amounts of goods as each other in two different years.
Since market exchange rates fluctuate substantially, when the GDP
(gross domestic product) of one country measured in its own
currency is converted to the other country's currency using market
exchange rates, one country might be inferred to have higher real
GDP than the other country in one year but lower in the other, both
of which inferences would fail to reflect the reality of their relative
levels of production. But if one country's GDP is converted into the
other country's currency using PPP exchange rates instead of
observed market exchange rates, the false inference will not occur.

FUNCTIONS:
The purchasing power parity exchange rate serves two main
functions. PPP exchange rates can be useful for making
comparisons between countries because they stay fairly constant
from day to day or week to week and only change modestly, if at
all,from year to year. Second, over a period of years, exchange
rates do tend to move in the general direction of the PPP exchange
rate and there is some value to knowing in which direction the
exchange rate is more likely to shift over the long run.

The PPP exchange-rate calculation is controversial because of the

difficulties of finding comparable baskets of goods to compare
purchasing power across countries.

In this case it is necessary to make adjustments for differences in

the quality of goods and services, knowing that a PPP calculated
using un country consumption as a base (U.S.A. = high bread
consumption0, will certainly be different from the PPP calculated
using another country consumption as a base (China = high rice
consumption).

Various ways of averaging bilateral PPPs can provide a more

stable multilateral comparison, but at the cost of distorting
bilateral ones. These are all general issues of indexing; as with
other price indices there is no way to reduce complexity to a
single number that is equally satisfying for all purposes.

For example, in 2005 the price of a gallon of gasoline in Saudi

Arabia was USD 0.91, and in Norway the price was USD 6.27.
The significant differences in price wouldn't contribute to
accuracy in a PPP analysis, despite all of the variables that
contribute to the significant differences in price. More
comparisons have to be made and used as variables in the overall
formulation of the PPP.
When PPP comparisons are to be made over some interval of time,
proper account needs to be made of inflationary effects.

LAW OF PRICES
Although it may seem as if PPPs and the law of one price are the
same, there is a difference: the law of one price applies to
individual commodities whereas PPP applies to the general price
level. If the law of one price is true for all commodities then PPP
is also therefore true; however, when discussing the validity of
PPP, some argue that the law of one price does not need to be true
exactly for PPP to be valid. If the law of one price is not true for a
certain commodity, the price levels will not differ enough from the
level predicted by PPP.

The risk that unexpected changes in consumer prices will penalize

an investor's real return from holding an investment. Because
investments from gold to bonds and stock are priced to include
expected inflation rates, it is the unexpected changes that produce
this risk. Fixed income securities, such as bonds and preferred
stock, subject investors to the greatest amount of purchasing
power risk since their payments are set at the time of issue and
remain unchanged regardless of the inflation rate.

The Big Mac index, also known as Big Mac PPP, is a survey done
by The Economist magazine that is used to measure
the purchasing power parity (PPP) between nations, using the
price of a Big Mac as the benchmark. Using the idea of PPP from
economics, any changes in exchange rates between nations would
be seen in the change in price of a basket of goods which remains
constant across borders. The Big Mac index suggests that, in
theory, changes in exchange rates between currencies should
affect the price that consumers pay for a Big Mac in a particular
nation, replacing the "basket" with the popular hamburger.
For example, if the price of a Big Mac is $4.00 in the U.S. as
compared to 2.5 pounds sterling in Britain, we would expect that
the exchange rate would be 1.60 (4/2.5 = 1.60). If the exchange
rate of dollars to pounds is any greater, the Big Mac Index would
state that the pound was over-valued, any lower and it would be
under-valued.

Although it may seem as if PPPs and the law of one

price are the same, there is a difference: the law of one price
applies to individual commodities whereas PPP applies to
the general price level. If the law of one price is true for all
commodities then PPP is also therefore true; however, when
discussing the validity of PPP, some argue that the law of
one price does not need to be true exactly for PPP to be
valid. If the law of one price is not true for a certain
commodity, the price levels will not differ enough from the
level predicted by PPP.
The purchasing power parity theory states that the exchange
rate between one currency and another currency is in
equilibrium when their domestic purchasing powers at that
rate of exchange are equivalent.

Purchasing power parity (PPP) states that the price of a good in one
country is equal to its price in another country after adjusting for the
exchange rate between the two countries.
As a light-hearted annual test of PPP, The Economist has tracked the
price of McDonald's Big Mac burger in many countries since 1986.
This experiment - known as the Big Mac PPP - and similar tests have
been underway for decades. Here we take a look at this unique
indicator, and find out what the price of the ubiquitous Big Mac in a
given country can tell us about its wealth.

An example of one measure of the law of one price, which underlies

purchasing power parity, is the Big Mac Index, popularized by The
Economist, which compares the prices of a Big Mac burger
in McDonald's restaurants in different countries. The Big Mac Index is
presumably useful because although it is based on a single consumer
product that may not be typical, it is a relatively standardized product
that includes input costs from a wide range of sectors in the local
economy, such as agricultural commodities (beef, bread, lettuce,
cheese), labour (blue and white collar), advertising, rent and real estate
costs, transportation, etc.

In theory, the law of one price would hold that if, to take an
example, the Canadian dollar were to be significantly overvalued
relative to the U.S. dollar according to the Big Mac Index, that
gap should be unsustainable because Canadians would import
their Big Macs from or travel to the U.S. to consume them, thus
putting upward demand pressure on the U.S. dollar by virtue of
Canadians buying the U.S. dollars needed to purchase the U.S.made Big Macs and simultaneously placing downward supply
pressure on the Canadian dollar by virtue of Canadians selling
their currency in order to buy those same U.S. dollars.
The alternative to this exchange rate adjustment would be an
adjustment in prices, with Canadian McDonald's stores compelled
to lower prices to remain competitive. Either way, the valuation
difference should be reduced assuming perfect competition and a
perfectly tradable good. In practice, of course, the Big Mac is not
a perfectly tradable good and there may also be capital flows that
sustain relative demand for the Canadian dollar. The difference in
price may have its origins in a variety of factors besides direct
input costs such as government regulations and product
differentiation.

In some emerging economies, western fast food represents an

expensive niche product price well above the price of
traditional staplesi.e. the Big Mac is not a mainstream
'cheap' meal as it is in the West, but a luxury import. This
relates back to the idea of product differentiation: the fact
that few substitutes for the Big Mac are available
confers market power on McDonald's. Additionally, with
countries like Argentina that have abundant beef resources,
consumer prices in general may not be as cheap as implied
by the price of a Big Mac.
The following table, based on data from The Economist's
January 2013 calculations, shows the under () and over (+)
valuation of the local currency against the U.S. dollar in %,
according to the Big Mac index. To take an example
calculation, the local price of a Big Mac in Hong Kong when
converted to U.S. dollars at the market exchange rate was
$2.19, or 50% of the local price for a Big Mac in the U.S. of
$4.37. Hence the Hong Kong dollar was deemed to be 50%
undervalued relative to the U.S. dollar on a PPP basis.

Price level (% relative to the

US)[10]

Country
Argentina

13

Euro area

+12

Australia

+12

Finland

+17

Austria

+5

France

+12

Belgium

+18

Germany

+13

Brazil

+29

Greece

+3

Britain

Hong Kong

50

Canada

+24

Hungary

13

Chile

India

63

China

41

Indonesia

35

Colombia

+11

Ireland

+8

Costa Rica

+1

Israel

Czech Republic

15

Italy

+20

Denmark

+19

Japan

20

Egypt

45

Latvia

25

Estonia

16

Lithuania

30