Purchasing Power Parity (PPP) is a theory stating that the foreign exchange rate between two countries should be equal to the ratio of the prices of a fixed basket of goods in each country. When this is true, the exchange rate is in equilibrium.
For example, if a Big Mac with fries costs $1.80 in the United States and $2.00 in Australia, the AUD/USD exchange rate would be 1.80/2.00 or 0.9000.
Purchasing Power Parity (PPP) is an important concept in international economics and finance that helps compare the relative value of currencies and the cost of living between different countries.
Purchasing power parity is a method of adjusting the exchange rate between two currencies to reflect differences in the price levels of goods and services in each country.
What is purchasing power parity?
The idea of purchasing power parity dates back to the 16th century, when Spanish academics first observed that a basket of goods should have the same price in two different countries when measured in a common currency.
This concept was later developed and refined by economists such as Gustav Cassel and Irving Fisher in the early 20th century.
The core idea behind PPP is the “Law of One Price,” which states that identical goods should cost the same in different countries when expressed in a common currency, assuming there are no transportation costs or taxes.
Purchasing power parity is often used to compare living standards between countries because it adjusts for differences in price levels and inflation rates.
How does purchasing power parity work?
To understand PPP, consider the following example: Suppose a pair of shoes sells for $100 in the United States and costs €80 in France.
The nominal exchange rate between USD and EUR is 1 USD = 0.8 EUR.
Using a nominal exchange rate, the shoe costs $64 in France ($1 * 80). However, this does not take into account the difference in the cost of living between the two countries.
Using purchasing power parity we can calculate the real exchange rate and adjust it for price level differences.
If the price of a shoe is the same in two countries, the real exchange rate will be 1 USD = 1 EUR, which means the shoe will cost USD 100 in both countries.
By comparing the real exchange rate with the nominal exchange rate, we can tell whether a currency is overvalued or undervalued.
Big Mac Index
The Big Mac Index, created by The Economist in 1986, is a light-hearted illustration of PPP, comparing the price of a McDonald's Big Mac burger in different countries.
By calculating Big Mac’s implied PPP exchange rate and comparing it to the actual exchange rate, we can tell whether a currency is overvalued or undervalued.
Why is PPP important?
PPP is an important tool in international economics and finance because it allows for meaningful comparisons of economic indicators such as GDP, income and inflation rates between countries.
It can help investors and policymakers identify currency misalignments, which may signal potential investment opportunities or the need for economic adjustment.
In addition, PPP is also crucial for international organizations such as the International Monetary Fund (IMF) and the World Bank to allocate resources and make policy recommendations.
What are the limitations of PPP?
While PPP is useful, it has some limitations. It assumes that all goods and services are tradable and there are no transportation costs or taxes, This is not the case in the real world.
Furthermore, PPP may not accurately account for differences in the quality of goods and services between countries.
Finally, the concept of PPP works better in the long run because short-term fluctuations in exchange rates may not accurately reflect changes in price levels.
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