PPP was established following World War I. Prior to the war, the gold standard was used by the majority of nations. The exchange rate of a country’s currency indicated how much it was worth in gold. In order to afford the war, most countries did away with the gold standard, opting to print money instead. As you can imagine, this led to inflation.

When the war ended, an economist from Sweden named Gustav Cassel proposed that currencies be valued by multiplying each currency’s worth before the war by its inflation rate. In so doing, he set the foundation for today’s PPP. 

The PPP idea was based on the law of one price. It argues that when prices are stated in the same currency, the same collection of goods and services will be equally valued across national borders. This was assuming zero transaction costs and trade barriers.

Definition

A currency’s purchasing power is the quantity of money it would take to purchase a common collection of goods and services in its native country. This power is influenced by factors such as the cost of living and the country’s inflation rate.

PPP is an economic notion that is used to assign the rates at which currencies trade for each other. It argues that barring transaction costs and barriers to trade, the same collection of goods should hold similar value in both countries. In simpler terms, if you convert the two currencies into one homogenous yardstick, this same collection will bear equal value in both nations. 

Example

Assume the exchange rate of USDCAD is 1USD=1.5CAD. If the cost of an apple in the US is $10, then in Canada, it should be 15.0 Canadian dollars.

But, if you look at the USDCAD market exchange rate, you’ll notice that it’s close to 1.24. The difference arises from the fact that the purchasing power of each of these currencies differs. There is the true worth of a currency and its notional value, which financial markets trade at, just like any other asset. This is where PPP comes in. It determines the relative value of currencies by accounting for variances in their purchasing power. 

Concepts used

1. Absolute purchasing power parity

The principle of absolute purchasing power parity (APPP) argues that a set of commodities should have the same value once two currencies have been exchanged. The theory is usually based on the conversion of other international currencies into US dollars.

Example

If the subscription of Netflix in the United States is $20 per month, absolute purchasing power suggests that the subscription should be the same in the UK after conversion to the pound sterling.

If this is not the case, the theory indicates that the currency exchange rate will fluctuate over time until the items are of similar value since there should be an equilibrium in the price of goods in the absence of trade restrictions. This is a price-level theory that exclusively considers the same set of items in each country, with no other considerations.

The hypothesis, however, has one limitation. It ignores factors that affect the currency in a country, such as inflation, which can influence the short-term exchange rate. The strength of a currency is poorly reflected without these features.

2. Relative purchasing power parity

The second notion, relative purchasing power parity (RPPP), is an extension of APPP. It argues that price inflation, to some extent, is responsible for currency exchange rates. However, it maintains that over time, the same collection of goods will be worth a similar amount in different nations. It considers how much of the collection a single unit of money can buy. This tends to fluctuate from time to time as the levels of inflation vary. Thus, the principle argues that inflation will reduce a currency’s purchasing power, which is why it must be considered when adjusting the PPP.

Example

When we apply this approach to absolute purchasing power parity, we can observe that inflation rates account for a portion of the change in currency value. Assume that the United States has a 2.2% inflation rate and Germany has a 4.5% inflation rate. This indicates that the price of a set of goods in Germany has risen by 4.5% in a year, whereas the price of the same basket of goods in the US has only risen by 2.2%.

Applications of purchasing power parity

When comparing the production of several countries, an economist would utilize the PPP. This is also the tool that can help identify the country with the world’s highest GDP. Other than calculating the GDP, PPP exchange rates can also shed light on the state of a country’s economic health. The CIA World Factbook uses PPP to rank countries by their gross output. 

PPP is also useful to forex traders and other investors who purchase foreign stocks and bonds. This is because it can be vital in forecasting price fluctuations of foreign currencies. Any sign of the currency’s weakness can be pointed out by this statistic. 

The PPP value can also be utilized by institutions that sell their wares in different countries. With it, they can compare the living standards between their client countries for marketing purposes. For example, KFC is a global conglomerate. They can compare living standards to determine what price to charge for their bucket of wings in the US and what price the UK bucket should go for.   

Disadvantages of using PPP

  • The traded items are not uniformly distributed.
  • International trade is hampered by a number of obstacles.
  • Government policies are being restrained (such as tariffs)
  • Merchandise price speculation
  • Costs of transportation
  • Costs of transactions
  • The re-adjustment of prices across multiple marketplaces is generally delayed by multinational firms.
  • For services and other non-tradable items, PPP analysis may not be applicable.
  • Even for homogeneous commodities, PPP analysis may not hold since price between economies is influenced by local market dynamics.

Conclusion

Purchasing power parity is a system used to shed insight into a country’s economic state. Abbreviated as PPP, it acts as a yardstick for the GDPs and economic size of different nations. It is difficult to calculate as it takes into account so many variables such as inflation and transportation costs. PPP can help investors make informed decisions while investing in different countries.

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