Purchasing Power Parity (PPP) is a theory that states that the foreign exchange rate between two countries should be equal to the ratio between their respective prices of a fixed basket of goods. When this holds true, the exchange rate is said to be in equilibrium.
For instance, if a Big Mac and fries cost $1.80 in the U.S. and $2.00 in Australia, then the AUD/USD exchange rate should be 1.80/2.00 or 0.9000.
Purchasing Power Parity (PPP) is an essential concept in international economics and finance, which helps compare the relative values of currencies and the cost of living between different countries.
In a nutshell, PPP is a method that adjusts the exchange rate between two currencies to account for differences in the price levels of goods and services in each country.
What is Purchasing Power Parity?
The idea of Purchasing Power Parity dates back to the 16th century when Spanish scholars first observed that a basket of goods should have the same price in two different countries when measured in a common currency.
The concept was later developed and refined by economists such as Gustav Cassel and Irving Fisher in the early 20th century.
The central idea behind PPP is the Law of One Price,’ which states that identical goods should cost the same in different countries when expressed in a common currency, assuming no transportation costs or taxes.
PPP is often used to compare the standards of living between countries, as it adjusts for differences in price levels and inflation rates.
How does Purchasing Power Parity work?
To understand PPP, consider the following example: Suppose a pair of shoes costs $100 in the United States and €80 in France.
The nominal exchange rate between the U.S. dollar and the euro is $1 = €0.8.
Using the nominal exchange rate, the price of the shoes in France would be $64 ($1 * 80). However, this does not account for differences in the cost of living between the two countries.
Using PPP, we can calculate the real exchange rate, which adjusts for price level differences.
If the shoes should cost the same in both countries, the real exchange rate would be $1 = €1, meaning that the shoes cost $100 in both countries.
Comparing the real exchange rate with the nominal exchange rate, we can determine whether a currency is overvalued or undervalued.
The Big Mac Index
The Big Mac Index, created by The Economist in 1986, is a lighthearted illustration of PPP that compares the price of a McDonald’s Big Mac burger in different countries.
By calculating the implied PPP exchange rate for the Big Mac and comparing it to the actual exchange rate, we can determine whether a currency is overvalued or undervalued.
Why is Purchasing Power Parity important?
PPP is an essential tool in international economics and finance, as it allows for meaningful comparisons of economic indicators such as GDP, income, and inflation rates between countries.
It helps investors and policymakers identify currency misalignments, which may signal potential investment opportunities or the need for economic adjustments.
Also, PPP is crucial for international organizations, such as the International Monetary Fund (IMF) and the World Bank, to allocate resources and make policy recommendations.
What are the limitations of Purchasing Power Parity?
Despite its usefulness, PPP has some limitations. It assumes that all goods and services are tradable and that there are no transportation costs or taxes, which is not the case in the real world.
Additionally, PPP may not accurately account for differences in the quality of goods and services between countries.
Finally, the concept of PPP works better in the long run, as short-term fluctuations in exchange rates may not accurately reflect changes in price levels.