Al Habtoor Group Research & Studies Department
Al Shindagah explains the theory of purchasing power parity and the effect it has on economies
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 depreciated in order to return to PPP.
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 expressed in the same currency.
The simplest way to calculate purchasing power parity between two countries is to compare the price of a ‘standard’ good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its ‘Hamburger Index’ that compares the price of a McDonald’s hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consume very different sets of goods and services, making it difficult to compare the purchasing power between countries.
For example, a particular TV set that sells for 750 Canadian dollars (CAD) in Toronto should cost 500 US dollars (USD) in New York when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Toronto was only 700 CAD, consumers in New York would prefer buying the TV set in Toronto. 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 the same price. There are three caveats with this law of one price.
1. As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.
2.There must be competitive markets for the goods and services in both countries.
3.The law of one price only applies to tradable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalisation of price levels across countries. Put formally, the exchange rate between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today’s exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US dollar will depreciate against the Canadian dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large.