Theory of Purchasing Power Parity

To compare economic productivity and standards of living between countries, economists use an analysis metric called the Purchasing Power Parity that allows them to compare different countries’ currencies through a “basket of goods” approach.

The Purchasing Power Parity (PPP) theory is a long-held belief that the exchange rate between two currencies should be the same regardless of whether one is considered more expensive or cheaper than the other.

  According to the PPP theory, any difference between the nominal exchange rates of two currencies stems from the fact that one currency is more or less convertible than the other and that each currency must be valued at its relative purchasing-power level. In other words, according to the PPP theory, a currency is not worth more or less than its trading partners are willing to pay for it. 

To determine the value of the dollar in terms of other international currencies, economists often refer to the exchange rate of the dollar against a basket of other currencies to determine the relative value of the dollar (Le., to compare the cost of imports relative to the price that U.S. exports command in foreign markets).

  The purchasing power parity rate is calculated by taking the price of a product in “currency 1” and dividing it by the price of that same product in “currency 2” and then multiplying the result by the overall population of each country to determine how much money it would take to buy equivalent amounts of goods and services in each nation (e.g., a single loaf of bread in the United States may cost $3, while a similar loaf would cost 10 times more in Japan). For example, suppose that the price of beef in the United States is $2 per pound, while the exchange rate between the U.S. dollar and the Japanese yen is ¥100 per dollar. Then we can say that the dollar is “worth” V200 in terms of Japanese yen and that a pound of beef in the U.S. costs the equivalent of ¥20,000 In Japanese yen. PPP calculations can also be used to compare the wealth of different nations. For instance, if a pound of beef in the United States costs $3, while a pound of beef in China costs only $1, we can say that the Chinese are wealthier than Americans because they have more buying power- a dollar in China can buy more goods than a dollar in the United States.

History of the Purchasing Power Parity theory:

This theory was originally developed within the School Of Salamanca during the 16th century. In 1916, the Swedish economist Gustav Cassel published his article The Present Situation of the Foreign Trade in which he took The Purchasing Power Parity theory to another level, he dived deeper into this concept and gave us what’s considered a modern form of the PPP model. Even though this theory has a long history in economics, the specific terminology of purchasing power parity was introduced in the years after World War I during the international policy debate concerning the appropriate level for nominal exchange rates among the major industrialized countries after the large-scale inflations during and after the war.

Since the early 1970s, the purchasing power parity theory of exchange rates has been the subject of an ongoing and lively debate. Especially between empirics and theory, to the point where they seemed to struggle to find common ground. For much of that period, theoretical work suggested that exchange rates should be linked to relative changes in price levels with deviations that might be only minimal or momentary, while empirical work could find only the flimsiest evidence in support of purchasing power parity, and even these weak findings implied an extremely slow rate of reversion to PPP of, at best, three to five years.

Drawbacks of Purchasing Power Parity:

As economists well know, the PPP model is not always accurate in practice

  •  Not all goods and services have identical prices across countries.
  •  economies are not perfectly competitive-some are dominated by monopolies or oligopolies that produce products that sell for a premium relative to their cost of production. 
  • It neglects transport costs: some products that are not available locally must be imported, which relatively increases the prices.
  • Tax Differences: Government sales taxes also have a direct impact on goods’ prices and result in differences between countries.

These factors can cause differences in the prices of goods and services in different countries even when the PPP model suggests that the prices are the same. Nevertheless, the PPP model remains a useful way of comparing the value of different currencies and of determining the relative wealth of different countries because it captures the overall trend of economic development over long periods of time.

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