Purchasing Power Parity

Imagine you want to buy a new textbook for your next class. Do you buy it in person, or go online and buy from a seller who might be anywhere in the world? Imagine it's available at a nearby store for $50, but the same new book is also available from a seller in another country, and the shipping is free! That seller's price is only twenty-five units of that country's currency. Twenty-five is only half of fifty, so the mail-order book is cheaper, right?

Of course not! Whether this is a good idea or not depends entirely on the exchange rate between the two currencies.

What might you expect the exchange rate to be in this situation? What would you do if you knew that the exchange rate equated to twenty-five units of the other currency with less than $50? That would mean your money gives you more purchasing power in the other currency! You may not realize it, but you just calculated purchasing power parity!

The next time you are considering buying something in another currency, you're going to be glad you read this explanation and learned all about Purchasing Power Parity!

Purchasing Power Parity (PPP) definition

Purchasing power is what money gives us--the ability to acquire goods and services for consumption. From one country to the next, does our purchasing power go equally far? That depends on the exchange rate between the two currencies. We might find it useful to start from a place where prices are equal everywhere, where the cost of an item in US dollars is the same as converting those US dollars into Euros and purchasing the same item.

If the purchasing power that can buy a basket of goods in one country is what also buys that exact same basket of goods in another country, then those countries are said to be in Purchasing Power Parity. This means that they have an exchange rate between their currencies that makes their prices equal to one another, for the same items or basket of items.

You can think of it as the nominal exchange rate that allows someone to acquire the same amount of goods and services in the two different counties with exactly the same amount of purchasing power.

PPP calculates this "reference point" exchange rate by comparing how much it would cost to purchase the same basket of goods in one country compared to the other. Any exchange rate above or below this suggests that one of the currencies is overvalued or undervalued. This creates an opportunity for people to shift purchases from one country to another, where they can acquire the same goods for less money, because the exchange rate gives them more purchasing power.

Purchasing Power Parity example

Let's consider the cost of a Big Mac in the US using dollars and in the UK using British pounds.

The price of a Big Mac in the UK is £3.39. We denote this as P_UK = £3.39.

The price of a Big Mac in the US is $5.71. Let's denote this as P_US = $5.71.

The actual exchange rate at the same point in time is = 0.79. That means $1 equals £0.79.

Now, we get the PPP exchange rate by dividing the price of the Big Mac in the UK by the price of the Big Mac in the US.

$PPP\hspace{0.17em}exchangerate=\frac{PriceofBigMacintheUK}{PriceofBigMacintheUS}=\frac{3.39}{5.71}=.59$

That is, 0.59 British pounds per US dollar is the exchange rate that makes these prices equal.

This means that for you to be able to buy the same Big Mac in the UK and the US with the same purchasing power, the exchange rate would have to be 0.59. Now, by comparing the actual exchange rate, which is 0.79, with the PPP exchange rate, we see that actual exchange rate is above the PPP. Specifically, $1 can be exchanged for 33% more British pounds than would be the case under parity.

This is only looking at a basket of one good, but if we were comparing the aggregate price level, we conclude that the British pound is undervalued by 33%. It suggests that purchases are cheaper in the UK than in the US because of the undervalued currency.

The Economist has developed the Big Mac Index, which tracks the PPP as measured by the price of a Big Mac in different countries.

Purchasing Power Parity theory

The purchasing power parity theory indicates that the nominal exchange rate between two countries' currencies is equal to the proportion of the countries' price level. It is an economic theory that suggests that the difference in the price level for the same basket of goods between two countries is what drives the equilibrium exchange rate between countries.

This price level can be considered a general price index made up of a different basket of goods and services. For example, in the United States, the consumer price index (CPI) is the price level of a different basket of goods.

One of the main underlying principles of the purchasing power parity is a concept known as "the law of one price." The law of one price is the idea that other things being equal, identical items sold on a worldwide market should have the same price. Goods and services that can be comparable in value and the equality they offer to customers will tend to converge towards the market equilibrium, resulting in the same prices for both countries.

Importance of Purchasing Power Parity

Purchasing power parity is critical for developing relatively reliable economic data that can be used to evaluate the market situations of various nations across borders.

Additionally, as there is a difference in purchasing power from country to country, it gives insight into the possible overvaluation or undervaluation of a country's currency. This is significant because currencies that are over or undervalued in terms of purchasing power parity (PPP) are likely to adjust over time, resulting in serious economic consequences as well as long-term swings in the currency's value.

For example, a local currency that PPP has assessed to be highly overpriced might be predicted to fall in value relative to frequently traded currencies such as the United States dollar over time.

Limitations of Purchasing Power Parity

Although the purchasing power parity theory helps provide a reference point for understanding changes in exchange rates, it has some limitations. Firstly, limitations can arise due to the difficulty in evaluating the same basket of goods in two countries. Even the same goods may actually be different because of differences in natural assets and cultural differences.

Second, people in two different countries can have different utility functions for the same basket of goods and therefore different consumption patterns. If their demand is significantly higher or lower, it may not be reasonable to expect the purchasing power to reach parity.

Third, many goods are also not traded easily, and even tradeable goods are not always perfect substitutes when they are produced in different countries. In particular, taxes and tariffs are not included, which are important because separate states' sales taxes can change the prices of commodities and services between nations and independent territories.

Below, we discuss four additional limitations of PPP: transportation cost, competition, cost of input, taxes.

Transportation Cost

When explaining trade between countries, PPP does not consider the transportation cost of moving goods between nations. It is much more expensive to bring goods from China to the US than from the UK to the US. This makes imported goods more expensive, which is not necessarily reflected in the exchange rate.

Competition

Some markets are less competitive, which means that more companies can charge higher prices. On the other hand, the companies at home don't have monopolistic power and resort to charging lower prices for the same good.

Cost of Inputs

For the basket of goods and services that we are trying to analyze, the price reflects other costs that are different for two different countries. Examples of these costs include utility bills and labor costs.

Taxes

Companies don't always pay the same taxes, which means that the price of goods will not be the same in other countries, hence providing a drawback for the PPP theory. In places where companies pay higher taxes per output sold, you would expect the output price to be much higher.

Types of Purchasing Power Parity

The two main types of purchasing power parity include: absolute purchasing power parity and relative purchasing power parity.

Figure 1. Types of Purchasing Power Parity, StudySmarter Originals

Absolute Purchasing Power Parity

Absolute purchasing power parity suggests that the two countries' price ratio is equal to the equilibrium exchange rate between the two countries. In other words, the exchange rate between the two countries is reflected in the basket of goods you are buying, and the amount of goods in the basket you get is the same for both countries.

In the presence of absolute purchasing power, there are no barriers such as distance or tariffs that would have an influence on the prices of the goods. It implies that the costs of the same basket of merchandise in various nations should be equivalent when considering other costs.

Relative Purchasing Power Parity

Relative purchasing power parity is when the ratio of the changes in the price level in two different countries is proportional to the change in the equilibrium exchange rate. According to relative purchasing power parity, when there are differences in the price levels between two countries, these differences will cause the exchange rate between two countries to change. The new exchange rate, influenced by the differences in the price level, will converge towards a new equilibrium point where price levels are at the same level.

Relative purchasing power parity is useful in explaining the long-run dynamics between price levels and the exchange rate. It suggests that the two will equal each other over the long run.

"The Big Mac index," The Economist. Feb. 2, 2022. https://www.economist.com/big-mac-index