Purchasing Power Parity Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The theory of purchasing power parity (PPP) explains movements in exchange rates by changes in countries’ price levels. It is derived from the “law of one price,” which says that identical goods should sell for the same price in all countries if there are no impediments to international trade. If prices for an identical good differ, a profit can be made by a process of “arbitrage”—buying the good from a low-priced country and selling it in the high-priced country. This process will alter supply and demand and force the prices to converge to a common equilibrium level in each country, when expressed in the same currency.

The theory of PPP is simply the application of the law of one price to all goods in an economy and thus to the general level of prices rather than to the price of a specific good. The exchange rate between two countries should thus equal the ratio of the prices of the baskets of goods used in the construction of the price indices that measure inflation. This is known as “absolute PPP,” because it refers to the exchange rate that should exist at a given point in time. In contrast, “relative PPP” is concerned with how exchange rates alter over time to maintain equal purchasing power. When a country’s price level is increasing at a faster rate than the price level in another country, its exchange rate must depreciate to counteract the higher inflation in order to return to PPP. This occurs because foreign demand for goods in the high-inflation country will decrease because of the higher prices, while home demand for foreign goods will increase because they are cheaper. If changes in actual exchange rates, known as “nominal” exchange rates, are fully offset by changes in inflation, then the “real” exchange rate will remain constant.

The ideas underlying PPP can be traced back to scholars at the University of Salamanca in the 16th century, although the term was first used by the Swedish economist Gustav Cassel (1918) when suggesting a means of adjusting the exchange rates of those countries intending to return to the gold standard after World War I to account for inflation. Cassel’s idea was picked up by John Maynard Keynes, who used it to argue against Winston Churchill’s decision to return the British pound to its prewar parity against gold in 1925, because it overvalued the currency relative to its PPP level; the criticism proved to be justified, because British exports duly declined and unemployment rose sharply.

A simple way of assessing whether PPP is valid is to compare the prices of similar, or identical, goods across countries. A well-known example of such an exercise is provided by The Economist magazine’s “Big Mac Index,” which divides the local price of McDonald’s Big Mac hamburgers around the world by the U.S. dollar price. By comparing this “PPP exchange rate” with actual exchange rates, the extent to which a currency is undervalued or overvalued can be measured. Although burgers cannot be traded across borders, and are thus not subject to arbitrage, the “Big Mac Index” nevertheless has an impressive record in predicting exchange rates, with currencies identified as overvalued tending to depreciate in later years.

The evidence from extensive testing of PPP is that the theory holds up well in the long run but poorly for shorter time periods and that it holds better for countries with relatively high inflation rates and underdeveloped capital markets. Deviations from PPP are caused by transport costs and barriers to trade, such as tariffs and quotas, which prevent arbitrage opportunities from being exploited. Deviations may also be because not all goods included in a price index are tradable. In addition, a component of household income is spent on services, such as healthcare, that cannot effectively be traded between countries and for which arbitrage, which drives PPP, is not therefore possible.

Because of deviations from PPP, international comparisons of gross domestic product per head using market exchange rates tend to give a misleading picture of international differences in productive potential and living standards. To correct for these differences, the United Nations International Comparison Project (ICP) collects data on the prices of goods and services for most countries in the world by calculating PPP exchange rates.

Bibliography:

Mikael Carlsson, Johan Lyhagen, and Pär Österholm, Testing for Purchasing Power Parity in Cointegrated Panels (International Monetary Fund, 2007);
Gustav Cassel, “Abnormal Deviations in International Exchange,” Economic Journal (v.28/112, 1918);
Imed Drine and Christophe Rault, Purchasing Power Parity for Developing and Developed Countries: What Can We Learn From Non-Stationary Panel Data Models? (CESifo, 2008);
Meher Manzur, Purchasing Power Parity (Elgar, 2008);
Organisation for Economic Co-operation and Development, Purchasing Power Parities and Real Expenditures: 2005 Benchmark Year (OECD, 2008);
Michael R. Pakko and Patricia S. Pollard, “Burgernomics: A Big Mac™ Guide to Purchasing Power Parity,” Federal Reserve Bank of St. Louis Review (v.85/6, 2003);
Alan M. Taylor and Mark P. Taylor, “The Purchasing Power Parity Debate,” Journal of Economic Perspectives (v.18/4, 2004);
United Nations, Handbook of the International Comparison Programme (United Nations Statistics Division, 1992).

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