PPP — Purchasing Power Parity

Purchasing Power Parity (PPP)

PPP - Purchasing Power Parity

Purchasing Power Parity PPP is a theory which suggests that exchange rates are in equilibrium when they have the same purchasing power in different countries.

Purchasing power parity will involve looking at a basket of goods to determine effective living costs. The purchasing power parity is determined by dividing a basket of goods in one country, by the cost of basket of goods in another.

A simple example of purchasing power parity

Suppose a Big Mac costs £2 in the UK and $4 in the US. The correct exchange rate according to purchasing power parity would by £1 equals $2. This would leave a customer indifferent to buying the good in the UK and buying it in the US.

Purchasing power and differences in prices

  • Suppose the Pound/Dollar exchange rate is £1 to $2.
  • If an Apple Mac costs £1,000 in the UK and $1000 in the US.
  • If a UK citizen was able to travel to US, he would only need £500 to convert into a $1,000. This suggests that it is much cheaper to buy the Mac in America. In this case, the current exchange rate is not reflecting the true living costs.
  • Therefore, UK citizens will want to import the good from America, this will involve selling pounds and buying dollars causing the Pound to depreciate.

If UK citizens want to buy more US goods, they will supply Pounds to buy dollars.

This will put downward pressure on the value of the Pound helping to move exchange rate closer to the purchasing power parity equilibrium.

Why can exchange rates differ from purchasing power parity?

Exchange rates often diverge from purchasing power parity for long periods of time. This reflects other factors such as the risk and stability of investing in a certain country.

  • If a country is seen as a safe haven, then investors will seek to save money in those assets. For example, investors are often keen to save in Swiss banks – causing the Swiss Franc to appreciate in value and make Swiss goods appear expensive. Conversely, if a country is seen as risky due to high inflation or debt default, this will cause the exchange rate to be undervalued as investors are reluctant to hold that currency.
  • If interest rates are much higher in the US than the UK, then this will cause hot money flows into the US as investors want to save in countries with higher interest rates.
  • Tax rates. Some visible prices may differ because of different tax rates. In Europe, VAT is often 20%, in the US, some state sales taxes are much lower.
  • Transport costs. Electronic goods in the US will tend to be cheaper because average transport costs are quite low. US retail firms benefit from economies of scale and being close to major ports. However, if you sold the same good, in say Bhutan, the good would have much higher transport costs, and so exchange rates will differ from the purchasing power parity.
  • Tariffs. Some countries may impose higher import tariffs (or non-tariff barriers) on goods, raising price beyond exchange rates
  • Living costs. Looking at the Big Mac index some of the cheapest places to buy a Big Mac are in the developing world or places with cheap rent. Big Macs are cheap, by international standards, but they are ly to be a big percentage of workers income because wages are low. Low wages enable firms to produce Big Macs at lower costs.

According to purchasing power parity which countries are overvalued?

The Euro and Yen look overvalued on purchasing power.

The Pound was overvalued in the dollar when it was at $2 to £1. This over-valuation was one reason why the Pound has consistently devalued in the past 15 years.

GDP per capita and GDP at PPP

Comparing GDP per capita at $US to PPP

Norway’s GDP per capita is $98,000, but when adjusted for PPP it falls to $62,000. This reflects the fact that wages are very high, but then living costs are also high. PPP gives a better indication of what you can actually buy in different countries.

India’s GDP per capita is $1,489, but because living costs are very low. The PPP is considerably higher.

Big Mac Index

A simple way to understand Purchasing power parity is to use one good. One of the most widely available goods is the McDonalds Big Mac. The Big Mac index looks at the US dollar price of a Big Mac (which in theory uses similar ingredients).

The US dollar price of a Big Mac varies, indicating that nominal exchange rates do not reflect the purchasing power parity of a currency. For example, in India a Big Mac is $1.62, but in Norway it is $6.79.

Source: Antti Vuorela CC BY-SA 3.0

Related

  • Understanding Exchange Rates
  • Factors influencing exchange rates

Источник: https://www.economicshelp.org/blog/1000/economics/purchasing-power-parity-ppp-for-exchange-rates/

Purchasing Power Parity Formula | PPP Calculation | Examples

PPP - Purchasing Power Parity

Purchasing power parity refers to the exchange rate of two different currencies that are going to be in equilibrium and PPP formula can be calculated by multiplying the cost of a particular product or services with the first currency by the cost of the same goods or services in US dollars.

The “purchasing power parity” is a term used to explain the economic theory that states that the exchange rate of two currencies will be in equilibrium or at par to the ratio of their respective purchasing powers.

The formula for purchasing power parity of country 1 w.r.t.

country 2 can be simply derived by dividing the cost of a particular good basket (say good X) in country 1 in currency 1 by the cost of the same good in country 2 in currency 2.

Purchasing power parity = Cost of good X in currency 1 / Cost of good X in currency 2

A popular practice is to calculate the purchasing power parity of a country w.r.t. The US and as such the formula can also be modified by dividing the cost of good X in currency 1 by the cost of the same good in the US dollar.

Purchasing power parity = Cost of good X in currency 1 / Cost of good X in US dollar

The PPP Formula can be derived by using the following four steps

  • Step 1: Firstly, try to figure out a good basket or commodity which is easily available in both the countries under consideration.
  • Step 2: Next, determine the cost of the good basket in the first country in its own currency. The cost will be reflective of the cost of living in the country.
  • Step 3: Next, determine the cost of the good basket in the other country in its own currency.
  • Step 4: Finally, the PPP formula of country 1 w.r.t country 2 can be computed by dividing the cost of the good basket in country 1 in currency 1 by the cost of the same good in country 2 in currency 2 as shown below.

Purchasing power parity = Cost of good X in currency 1 / Cost of good X in currency

Example #1

Let take the example of purchasing power parity between India and the US. Suppose an American visits a particular market in India. The visitor bought 25 cupcakes for Rs.

250 and remarked that cupcakes are quite cheaper in India. The visitor claimed that on an average 25 such cupcakes cost $6.

the given information calculate the purchasing power parity between the two countries.

Given, Cost of 25 cupcakes in INR = Rs.250

Cost of 25 cupcakes in USD = $6

Therefore, the purchasing power parity of India w.r.t US can be calculated as,

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Purchasing power parity = Cost of 25 cupcakes in INR / Cost of 25 cupcakes in USD

= Rs.250 / $6

Calculation of Purchasing Power Parity of India w.r.t US will be,

Purchasing Power Parity of India w.r.t US = Rs.41.67 per $

Therefore, the purchasing power parity ratio of the exchange for cupcakes is USD1 = INR41.67.

Example #2

Let’s take another example to compute purchasing power parity between China and the US. In January 2018, a McDonald’s Big Mac costs $5.28 in the US, while the same Big Mac could be bought for $3.17 in China during the same period. the given information calculate the purchasing power parity between the two countries.

[Exchange rate $1 = CNY6.76]
  • Given, Cost of Big Mac in CNY = 3.17 * CNY6.76 = CNY21.43
  • Cost of Big Mac in USD = $5.28

Below table shows data for the calculation of purchasing power parity between China and the US.

The calculation of Cost of Big Mac in CNY will be,

Cost of Big Mac in CNY = 3.17 * CNY 6.76 = CNY 21.43

Therefore, the purchasing power parity of China w.r.t US can be calculated as,

Purchasing power parity = Cost of Big Mac in CNY / Cost of Big Mac in USD

= CNY 21.43 / $5.28

Calculation of Purchasing Power Parity of China w.r.t US will be,

Purchasing Power Parity = CNY4.06 per $

Therefore, the purchasing power parity ratio of the exchange for Big Mac is USD1 = CNY4.06.

Purchasing Power Parity Calculator

You can use these Purchasing Power Parity Calculator

Purchasing Power Parity Formula =
Cost of good X in currency 1
=
Cost of good X in currency 2

Relevance and Use

It is very important to understand the concept of PPP formula because it is required to compare the national incomes and the standard of living of various nations.

Hence, the metric of purchasing power parity between two countries represents the total number of goods and services that a single unit of the currency of one country will be able to purchase in another country, taking into consideration the price levels in both countries.

Therefore, when the theory of purchasing power parity holds good, then this metric should be equal to unity.

Another major application of the purchasing power parity is in the calculation of the gross domestic product of a nation as it helps in offsetting the impact of inflation and other similar factors.

The metric mitigates the problem of the large difference in inflation rates across nations and aid in the measurement of the relative outputs of various economies and their living standards. The variables purchasing power parity show the real picture, thus allowing comparison.

As such, the purchasing power parity method plays a significant part and are preferred in the analyses that are carried out by researchers, policymakers, and other private institutions. The variables purchasing power parity do not show major fluctuations in the short run.

In the long run, the metric exhibits somewhat variation which is indicative of the direction of movement of the exchange rate.

This has been a guide to Purchasing Power Parity Formula (PPP). Here we learn how to calculate Purchasing Power Parity (PPP) using practical examples along with downloadable excel templates. You may learn more about Financial Analysis from the following articles –

Источник: https://www.wallstreetmojo.com/purchasing-power-parity-formula/

Purchasing Power Parity Adjustments (PPP)

PPP - Purchasing Power Parity

In order to properly understand the importance of the PPP method, we start by republishing here an article we earlier wrote on the topic under the heading Why the PPP method is more accurate for GDP comparisons.[1]

According to figures from the IMF, Russia’s GDP exceeded $4.2 trillion in 2018. By this measure, Russia is the 6th largest economy in the world, virtually on par with Germany, who scored $4.35 trillion.

At the same time, China has solidified its position as the world’s indisputably largest economy. With its $25.27 trillion, China’s economy is already bigger 1/5th than the U.S. economy with its $20.49 trillion.

These GDP figures are calculated according to the PPP method. PPP stands for purchasing power parity and it aims to capture the value of the real economic output contrary to the method of rendering GDP in nominal USD figures.

The nominal method, converts a country’s GDP calculated in the local currency to the USD using the market exchange rates. The figures calculated with the nominal method is what the media tends to report. But, the Nominal GDP method contains several grave errors.

There is a huge calculation bias in favor of the countries possessing the dominant world currencies, that is, the Western countries. Thanks to the dominant currencies, their GDPs tend to be inflated in value as compared with the countries with currencies that are not widely used globally.

This way, the economies of the Western countries would seem bigger than they are if one only goes by the nominal market exchange value.

High taxes and a high general level of prices also push up the nominal GDP, again making the Western economies seem bigger than they are.

GDP is statistics fraught with assumptions

Before we proceed further, we must note that any GDP (Gross Domestic Product) calculation is a statistical exercise a host of assumptions on how to arrive to the total value of everything produced. Therefore, the step from Nominal GDP to PPP method is just one of the thousands of assumptions, the one method is not more exact input data than the other.

The volume of the economy is expressed in a monetary form, because that is the only way you can make all the millions of products statistically comparable, but what we really need to know is how much of each product has been produced, how many cars, how many houses, how many tomatoes etc. But, by using the USD exchange rate as the multiplier we lose the comparability. (Global GDP comparisons are always given in USD).

If one kilo of tomatoes costs 90 rubles or 1.5 USD in Russia and 4.5 USD in the United States, then according to the Nominal method the U.S. economy would be 3 times bigger by this parameter, even though both countries would produce the same amount of tomatoes.

In fact, on average, almost everything is 3 or 4 times less expensive in Russia, therefore, by converting the Russian prices to USD according by the market exchange rate, Russia’s economy would seem 3 to 4 times smaller than it actually is.

This is where the PPP method comes in to remove the calculation biases and currency fluctuations. The PPP method looks beyond the US dollar, striving to capture the actual volume of goods and services produced in a country.

In comparing the size of the economy of different countries, that is precisely what we want to do, to measure their real output of goods and services.

The PPP method adjusts the dollar GDP to the comparative price levels

The starting point for the PPP GDP is the Nominal GDP calculated in the local currency of any country. This is then adjusted by the PPP coefficient, which is the average price difference between products in the given country and the U.S.

The local GDP figure is multiplied with the PPP coefficient and this way we reach the more accurate comparison of the actual volumes of the economies.

We are still using the USD as the currency for comparing all the world’s economies, but have adjusted them to eliminate the market exchange rate biases.

Another way to express this is to say that we check how much of any given product we can by for one dollar in various countries. Any expat and even tourist experiences something similar on a daily basis when they are in a foreign country, observing what their money buys there compared with at home.

The so-called Big Mac index, which compares the price of McDonald’s Big Mac sandwich around the world can serve to illustrate the differences in price levels of various countries. (The idea being that as the product and the production method is highly standardized, it would tell something about the general price level differences). In the U.S.

a Big Mac costs on average 5 dollars, while the price in Russia is 2 dollars. Thus by this indicator alone the Russian economy would look artificially lower by 2.5 times using the Nominal method and its market exchange rate.

(In reality McDonald’s prices are not the best indicator, because the prices are still higher than the general level of prices due to McDonald’s brand dominance, franchising royalties etc.)

Quality of products is not the explainer

The adherents to the Nominal GDP method maintain that what explains the price difference is supposedly quality, a better Western product is more expensive because it is of better quality, they say. Obviously, quality affects the comparative prices, but only to a certain degree, and often not at all.

Let’s go back to the example of tomatoes, many claim – and I agree – that tomatoes in Russia, as well as vegetables in general, are often tastier than those in Europe, yet they are cheaper, so for sure quality is not what explains the price difference in these cases.

Or how about a haircut? I can get it for 3 dollars in Moscow and 20 in Helsinki, and really there is no difference in the result.

The PPP method thus assesses the actual economic output of goods and services disregarding the distortions of currency exchange rates and all the structural differences on the markets of the various countries, contrary to the wrongheaded nominal GDP method.

In the case of Russia, a particularly good example is the arms industry. Lately, it has been proven beyond any doubt that Russia’s weapons, aircraft, missile systems, tanks etc. are by no means inferior in quality to the American ones, yet they cost much less. This article[2] argues that the PPP  difference in the arms industry could be as high as tenfold in Russia’s favor.

The final nail in the coffer of the Nominal GDP method

I often find myself in online arguments with Nominal GDP apologists, where I go through all these arguments and many more. But, they just go on and on, till we come to the final argument that would shut them up – literally. I tell them that Russia’s nominal GDP in 2016 was $1.28 trillion and it is expected to reach $1.47 trillion by 2017.

That’s a 14.5% growth, I point out, and then I ask them to explain how Russia has reached this absolutely spectacular growth. “That’s not real growth, it’s just the exchange rate difference when the ruble appreciated,” they frown. – Exactly, that’s what it is. That’s what the Nominal GDP is, an illusion fluctuating and biased exchange rates.

PPP and tax adjusted income, Russia compared with Finland

As it was shown, a proper comparison of income levels between countries would have to consider both the difference in price levels (PPP adjustments) and the tax burden, so that income would be compared net of taxes and adjusted to the respective price levels. Both these adjustment vastly favor Russia, in the sense that it shows Russia’s true comparative wealth and well-being. This point is well illustrated by comparing the adjusted salaries of Russia and Finland.

The nominal gross average monthly salary in Russia of $775[3] –  pales – at a superficial glance – in comparison to the $3,730 of Finland.[4] But after a 30.4% tax, the salary in Finland would be worth $2,700[5] whereas in Russia $687 would be left after a 13% flat tax.

The PPP conversion factor between the price levels in Finland and Russia is 2.68, meaning that prices in general and on average are 268% higher in Finland.[6] Therefore, we must multiply the Russian net salary by 2.68 to make it comparative with the Finnish. This gives $1,840.

Alternatively, we could divide the Finish salary by the PPP factor to compare it downwards with the Russian salary, yielding $1,000.

In the latter case we would see that the $3,730 which seemed to be a vastly higher salary in Finland in actual reality is worth $1,000 (in the home country) compared with the actual value of $687 of the Russian nominal gross salary of $775.

In April 2018, the average salary in Moscow was 89,000 rubles, the equivalent of $1,465. Making the same adjustments as above, this would yield the purchasing power comparable value with Finland of $3,410. In Finland you would have to earn $6,500 to achieve the same purchasing power as the Moscow $1,465.

Net of tax and adjusted for purchasing power, a monthly salary of $3,700 in Finland equals a salary of $1,150 in Russia.

The above examples should make it clear how illusional the nominal income and nominal wealth comparisons are if they are not adjusted for purchasing power parity and indeed taxes, too. For further reading, we refer to Awara Global Survey on Total Payroll Taxes 2014[7]

[1] Jon Hellevig at Awara Accounting blog https://www.awaragroup.com/blog/despite-sanctions-russias-gdp-shoots-over-4-trillion/

[2] http://russia-insider.com/en/russia-and-china-will-win-new-arms-race/ri13258 [3] Rosstat gives $674 for 2017, we have adjusted that with the income paid in the shadow sector, as explained in this report [4] Data from 2016 https://yle.fi/uutiset/3-9843295 [5] We refer to the calculations of the Finnish Taxpayers Association of effective tax for various income levels https://www.veronmaksajat.fi/luvut/Laskelmat/Palkansaajan-veroprosentit/ [6] The PPP conversion factor is calculated by comparing the nominal GDP and PPP GDP as reported by the IMF [7] Jon Hellevig at Awara Accounting blog https://www.awaragroup.com/blog/survey-on-total-pay-roll-taxes-2014/

Источник: https://www.awaragroup.com/blog/purchasing-power-parity-adjustments/

Purchasing Power Parity (PPP) Theory of Exchange Rate

PPP - Purchasing Power Parity

Purchasing Power Parity Theory (PPP) holds that the exchange rate between two currencies is determined by the relative purchasing power as reflected in the price levels expressed in domestic currencies in the two countries concerned.

Changes in the exchange rate are explained by relative changes in the purchasing power of the currencies caused by inflation in the respective countries.

The concept of Purchasing power parity theory (PPP) is traced to David Ricardo, but the credit for stating the law in an orderly manner is given to the Swedish economist Gustav Cassel who proposed it in 1918 as a basis for resumption for normal trade relations at the end of First World War.

The  Purchasing Power Parity Theory is stated in two versions :

  1. The stronger absolute version of Purchasing Power Parity, and
  2. The diluted relative version of Purchasing Power Parity.

Absolute Version of Purchasing Power Parity

The absolute version of  Purchasing Power Parity is the law of one price.

This law states that under conditions of free market with the absence of transportation costs, tariffs and other frictions to free trade, the price for identical goods should be the same at any market when measured in terms of a common currency.

To give an example, suppose a particular quality of coffee seeds cost Rs 100 a kg in India and the same commodity costs 2$ in USA.

The exchange rate between US dollar and Indian rupee in the market will be Rs 50 so that when the dollar price of coffee is converted into rupees will be the same Rs 100 as prevailing in the domestic market. If the exchange rate in the market is anything other than Rs 50 it will lead to arbitraging opportunities. The arbitraging operations will ultimately lead the exchange rate to the equilibrium level.

To explain how arbitraging operations will restore the exchange rate to Rs 50 per dollar, let us suppose that the market rate for dollar is Rs 45. In the absence of transaction costs, traders in India will find that coffee is priced low in terms of dollars as compared to its rupee price.

They will find it advantageous to buy coffee in USA and sell in the domestic market. Suppose a trader imports 1000 kgs of coffee. He will pay Rs 90,000 to acquire the required 2,000$ from the market. He can sell 1000 kgs of coffee in the domestic market at Rs 100 a kg and earn Rs 1,00,000.

This results in a profit of Rs 10,000 to the trader.

Similar operations will be done by all the traders in India. The   combined effect of the operations of   all the traders in India is that the demand for dollars increases in the foreign exchange market, pushing its prices in terms of rupees. With successive deals the dollar keep as appreciating.

The arbitrating profit is reduced with the appreciation of dollar. For example if dollar moves to Rs 47, the net profit is reduced to Rs 3 a kg from Rs 5 a kg available earlier. The appreciation of dollar will continue until the arbitrating profit is totally eliminated.

That is the level where price of coffee is same when measured in terms of either rupees or dollar.

If the ruling exchange rate is Rs 54 per dollar, traders in India will find it advantageous to sell coffee in USA to get higher rupee realization. For instance, a trader can buy 1000 kgs of coffee for Rs 100,000 and sell them for 2,000$ in the US market.

By selling the dollars in the foreign exchange market at Rs 54, he will realize Rs 1,08,000 and thus gain Rs 8000. Similar operations by all traders will increase the supply of dollars in the market exerting a downward pressure on its price in terms of rupee.

The exchange rate will move to a level where arbitrating is no more possible.

While the law of one price relates to a single product, PPP theory does not confine to a single product. Instead of a single commodity we may consider a basket comprising a variety of products. If a basket of commodities costs Rs 10,000 in India and the same set of commodities costs 200$ in USA , the dollar will be quoted at Rs 50 in the foreign exchange market.

The absolute version of PPP can be stated symbolically as

e =   Pd/Pf

where,

  • e = exchange rate for the foreign currency in terms of the domestic currency.
  • Pd = Price in domestic currency.
  • Pf = Price in foreign currency.

If the price in the domestic market rises relative to the price level in the foreign market, the domestic currency will depreciate proportionately against the foreign currency.

In the above example, if the cost of the basket increases to Rs 11,000 in India, while the price does not change in USA, the dollar will now be traded at Rs 55 to maintain the price parity (indicating depreciation of rupee or equivalently appreciation of dollar).

Relative Version of Purchasing Power Parity

The absolute version of  Purchasing Power Parity is unrealistic assumptions of free trade, no transportation costs and identical commodities. Transportation costs are a big hurdle in benefiting from lower prices in another market.

Movement of goods and services are not free. The commodities in any basket are not identical and they may differ in quality. Further, there are certain goods which do not enter international trade.

Examples of non-traded goods are housing and personal services health and haircut.

Therefore it is granted that the exchange rate in the market may differ from the absolute PPP. For instance , when the cost of a basket of commodities is Rs 10,000 in India and 200$ in the USA, the market may quote Rs 45 per dollar. What is expected is that the exchange rate will move along with the relative changes in prices in the two countries.

If the price of the basket of commodities increases to Rs 11000 in India and the basket is now costing 212$ in USA, the rupee will suffer a depreciation in relation to dollar. The extent to which the rupee will depreciate is the difference in the inflation rates in the two countries during the period. In the given example the inflation was 10%   in India and 6% in USA.

The rupee will depreciate approximately by 4% to quote about Rs 46.80.

In order to main the PPP, the change in the exchange rate should be proportionate to the change in the relative purchasing power of the currencies concerned. Therefore,

New exchange rate/ Old exchange rate = Proportionate change in domestic price/ Proportionate change in foreign price

Symbolically this can be stated as

et = e * (1+Id)/(1+If)

where,

  • et = expected exchange rate after period t.
  • Id = rate of domestic inflation during period t.
  • If = rate of foreign inflation during period t.

et = 45* (1.1/1.06)= Rs 46.70

In practice , in the place of a basket of goods, price indices are used to compute the Purchasing Power Parity. To begin with, suppose the price index in India and USA   are 100 and the exchange rate is Rs 45 a dollar. At the end of the period, the price index in India is 115 and in USA is 108. The exchange rate will move to Rs 47.92 as computed ,

Et/45 =(115/100)/(108/100)

Et= Rs 47.92

Nominal Exchange Rate and Real Exchange Rate

The exchange rate as quoted in the foreign exchange market are nominal exchange rates. For instance, if dollar earlier in the market at Rs 45.00 is now quoted at Rs 45.40, the dollar has appreciated by 40 paise in nominal terms.

When the inflation rate in two countries differs, the change in the nominal exchange rate is expected. The PPP will hold if the change in nominal terms equals the inflation differential between the two countries.

In the earlier example, when the inflation differential was 4% and the nominal exchange rate moved from Rs 45 to Rs 46.70 , the PPP between the dollar and rupee was maintained.

A change in the nominal exchange rate does not alter the export competitiveness of the countries , so long as the movement is in accordance with the inflation differential and the PPP is not changed.

Real exchange rate is the nominal exchange rate as adjusted for inflation. For computing the real exchange rate there should be a base period exchange rate. Current nominal exchange rate is discounted for the inflation differential to arrive at the real exchange rate.

If the inflation adjusted exchange rate is same as the base period exchange rate, there is no change in the real exchange rate during the period. If the inflation adjusted exchange rate is higher than the base period exchange rate, there is depreciation of the home currency in real terms.

If the inflation adjusted exchange rate is lower than the base period exchange rate, the home currency has depreciated in real terms against the foreign currency.

Deviations From Purchasing Power Parity

Changes in the real exchange rates can be seen as deviations from PPP. In the given example, against dollar the rupee deviated from PPP by 40 paise.

This is same as the real exchange rate changes, allowing for the difference due to different bases.

It may be understood that it is the real exchange rate that affects the competitiveness of a country and not the nominal exchange rate changes.

Empirically it is found that PPP holds only in a very long period. During short term and over medium term, the exchange rate in the market differs significantly from the PPP. The reasons for this deviation are :

  1. Price Indices: There are different price indices wholesale price index and consumer price index with different constituents. Even if we use the same index in the two countries concerned, each country follows its own composition and assigns its own weights. Therefore there are no identical indices which the inflation differential can be calculated accurately.
  2. Inclusion of non-traded goods: The price indices are the changes in prices of traded as well as non-traded goods. The exchange rates in the market are affected only by changes in the prices of traded goods. It is common knowledge that during a given period, in any country, all the goods do not undergo price changes to the same extent. A price index which includes both traded and non-traded goods is influenced by price changes in both types of goods. To the extent the weights assigned to each type differs between the indices, the effect of changes in the price of traded goods on the price index varies. The actual PPP tends to be different from that suggested by the price indices by the inclusion of non-traded goods in the index.
  3. Stickiness of the price of goods price: In many cases the prices of goods are determined by the manufacturers on the basis of various factors, other than the cost of production.
  4. Government interference: Govt. interference in the form of tariffs and other hindrances to free flow of international trade does not permit the arbitrageurs to take advantage of the price differences in two markets.
  5. Liberalization of markets: With the liberalization of markets, the cross border movement of cash for capital transactions and speculative activities have gained greater importance. The exchange rate is now determined not only by movement of goods and services.
  6. Price discrimination by MNCs: Multinational firms adopt the policy of price discrimination by market segmentation leading to the same product being priced differently in different markets.

Источник: https://www.mbaknol.com/international-finance/purchasing-power-parity-ppp-theory-of-exchange-rate/

Purchasing Power Parity — Learn How to Construct and Use PPP

PPP - Purchasing Power Parity

The concept of Purchasing Power Parity (PPP) is used to make multilateral comparisons between the national incomesGDP FormulaThe GDP Formula consists of consumption, government spending, investments, and net exports. We break down the GDP formula into steps in this guide.

Gross Domestic Product (GDP) is the monetary value, in local currency, of all final economic goods and services produced in a country during a specific period of time. and living standards of different countries. Purchasing power is measured by the price of a specified basket of goods and services.

Thus, parity between two countries implies that a unit of currency in one country will buy the same basket of goods and services in the other, taking into consideration price levels in both countries.

A PPP ratio measures deviation from the condition of parity between two countries and represents the total number of the baskets of goods and services that a single unit of a country’s currency can buy.

Origin of Purchasing Power Parity

The concept originated in the 16th century and was developed by Swedish economist, Gustav Cassel, in 1918. The concept is the “law of one price,” which states that similar goods will cost the same in different markets when the prices are expressed in the same currency (assuming the absence of transaction costs or trade barriers).

Purchasing Power Parity and Exchange Rates

One may argue that the market exchange rateForex Trading — How to Trade the Forex MarketForex trading allows users to capitalize on appreciation and depreciation of different currencies. Forex trading involves buying and selling currency pairs each currency's relative value to the other currency that makes up the pair. can be a measure of deviation from PPP.

However, the exchange rate between two countries typically is determined by the supply and demand forces of the traded goods, services, and assets; the prices of non-traded goods are not taken into consideration, which leads to inaccuracy while comparing living standards. An example will make this clearer.

Let the US dollar be equivalent to 60 Indian rupees (1$ = 60). An American visits India and goes to the market. She buys 10 cupcakes with 120 and remarks, “Cupcakes are cheaper here!” In the US, she buys 10 similar cupcakes for $3.

Now, $3 = 180, which means 15 cupcakes in India! So, the PPP ratio of the exchange for cupcakes is $3 = 120, that is, $1 = 40.

However, since cupcakes are not traded, the market exchange rate does not incorporate the fact that they are “cheaper” in India. wise, all non-traded goods are not represented in the market exchange rate in the two countries.

As in this case, it is generally seen that the official exchange rate will understate the living standards of developing countries. This is because developing countries tend to achieve factors of production, i.e.

, unit labor costs are generally lower, which results in the non-traded goods being mostly cheaper (the Balassa-Samuelson effect, among others, provides a different explanation regarding the price differential between traded and non-traded goods).

As a country develops, it is generally believed that more goods will be traded and that the gap between the PPP exchange rate and the market exchange rate will diminish.

PPP ratios help in making more meaningful comparisons of living standards in different countries.

Uses of Purchasing Power Parity

Large differences in inflation rates across the globe make it impossible to accurately compare and measure the relative outputs of economies and their living standards. PPP-based variables are in real terms, thus allowing comparison. The following diagram shows the difference between GDP measured in nominal terms and PPP-based GDP, the latest estimates.

PPPs play a vital role and are preferred in the analyses carried out by policymakers, researchers, and private institutions, as they do not show major fluctuations in the short run. In the long run, PPPs somewhat indicate in which direction the exchange rate is expected to move as the economy develops further.

Constructing Purchasing Power Parity

The general method of constructing a PPP ratio is to take a comparable basket of goods and services consumed by the average citizen in both countries and take a weighted average of the prices in both countries (the weights representing the share of expenditure on each item in total expenditure). The ratio of the prices will be the PPP rate of exchange.

Indexes such as the Big Mac Index and KFC Index use the prices of a Big Mac burger and a bucket of 12-15 pieces of chicken, respectively, to compare living standards between countries. These are moderately standardized products that include input costs from a wide range of sectors in the local economy, which makes them suitable for comparison.

Reliability of Purchasing Power Parity

Although it is widely used, PPP ratios may not always portray the real standard of living in countries, for the following reasons:

  • The underlying expenditure and price levels that represent consumption patterns may not be reported correctly.
  • It is difficult to construct identical baskets of goods and services while comparing dissimilar countries, as people show different tastes and preferences, and the quality of the items vary.
  • The prices of traded goods are rarely seen to be equal, as there are trade restrictions and other barriers to trade which result in deviation from PPP.

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  • Market EconomyMarket EconomyMarket economy is defined as a system where the production of goods and services are set according to the changing desires and abilities of
  • Fiscal PolicyFiscal PolicyFiscal Policy refers to the budgetary policy of the government, which involves the government manipulating its level of spending and tax rates within the economy. The government uses these two tools to monitor and influence the economy. It is the sister strategy to monetary policy.
  • Law of SupplyLaw of SupplyThe law of supply is a basic principle in economics that asserts that, assuming all else being constant, an increase in the price of goods will have a corresponding direct increase in the supply thereof.  The law of supply depicts the producer’s behavior when the price of a good rises or falls.
  • Consumer Surplus FormulaConsumer Surplus FormulaConsumer surplus is an economic measurement to calculate the benefit (i.e., surplus) of what consumers are willing to pay for a good or service versus its market price. The consumer surplus formula is an economic theory of marginal utility.

Источник: https://corporatefinanceinstitute.com/resources/knowledge/economics/purchasing-power-parity/

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