Purchasing power parity

In economics, purchasing power parity (PPP) is a theory which says that the long-run equilibrium exchange rate of two currencies is the rate that equalizes the currencies' purchasing power. This theory is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price.

Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relation between the two countries' relative inflation rates and the change in the exchange rate of their currencies.

A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Market exchange rates fluctuate widely, but many people believe that PPP exchange rates reflect the long run equilibrium value. The distortions caused by using market rates are accentuated because prices of non-traded goods and services are usually lower in poorer economies. For example, a US dollar exchanged and spent in China will buy much more than a dollar spent in the United States.

The differences between PPP and market exchange rates can be significant. For example, GDP per capita in China is about USD 1,500, while on a PPP basis, it is about USD 6,200. At the other extreme, Japan's nominal GDP per capita is around USD 37,600, but its PPP figure is only USD 31,400.

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices or in the opposite direction of the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task, since purchasing patterns and even the goods available to purchase differ across countries. It is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

Where PPP comparisons are made over some interval of time proper account needs to be made of inflationary effects.

Explanation

For a US dollar to buy as much in the UK as in the US, as is assumed under the law of one price, the price of a basket of goods in pounds in the UK times the spot exchange rate should equal the price of the same basket in the US priced in dollars.

£P ($/£)= $P

This implies that the exchange rate that equalizes the value of a dollar of purchasing power (the PPP exchange rate) is:

($/£)= $P/£P

If the actual spot rate is greater, it suggests that the £ is over-valued against the $. If the actual spot rate is less, it suggest that the $ is over-valued against the £.

For example if a "representative" consumption basket costs $1,500 in the US and £1,000 in the UK the PPP exchange rate would be $1.50/£. If the actual spot rate was $1.80/£ this would indicate that the pound is overvalued by 20%, or equivalently the dollar is undervalued by 16.7%.

Relative PPP

Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate.

$\frac{S_t}{S_{t-1}}=\frac{P_{t}^*/P_{t-1}^*}{P_{t}/P_{t-1}}$ ,

where $S_t$ is the spot rate in Foreign Currency/Domestic Currency and $P_t$ is the price level in period t (foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasing power parity.

According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the USD should depreciate by 2% compared to the purchasing power of the EUR (equivalently the EUR will appreciate by about 2%).

PPP equalization and the law of one price

The law of one price states that differing prices of a traded good will tend to equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates. The law of one price can also be stated as: "In an efficient market all identical goods must have only one price."

The naïve PPP hypothesis is that free trade of goods should revert exchange rates to their PPP values. However, econometric analysis rejects this hypothesis, and gives a better prediction of the PPP/exchange rate relationship (the CPI) based on relative GDPs. Neo-classical economics includes Balassa-Samuelson effect theory, which explains the PPP model adjustment giving the equilibrium CPIs.

Big Mac Index

An entertaining example of one measure of PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD 4 in the US and GBP 3 in Britain, the PPP exchange rate would be £3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, tomatoes), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc.

Examples

West and Central African Franc

In 2003 the US Dollar bought on average about 550 CFA franc. Because of a difference in purchasing power within some of the regions using the CFA franc, their purchasing power parity exchange rate differed greatly (lower implies a stronger currency): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167.

GDP of China

The CIA uses the purchase power parity (PPP) method in its calculations of Gross National Product ^*. By this measure the People's Republic of China has the third largest economy in the world, at $8.182 trillion (2005 est.) (CIA methodology for PPP). However, the empirical foundation for all PPP estimates for China is weak, since no comprehensive survey of Chinese prices has ever been carried out by the International Comparison Project. Prices behind existing PPP estimates are few, out of date and may be unrepresentative of today's price structure.

Need for PPP adjustments to GDP

Using market exchange rates to compare countries' standard of living or per capita Gross Domestic Product can give a very misleading picture. The PPP method is used as an alternative.

For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are any poorer; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

Difficulties

The main reasons why PPP does not perfectly reflect standards of living are

PPP numbers can vary with the specific basket of goods used, making it a rough estimate.
Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
International competitiveness is mainly affected by the exchange rate and not by PPP.
Differences in quality of goods are not sufficiently reflected in PPP.

PPP calculations are often used to measure poverty rates. For problems with this methodology, see How Not To Count The Poor.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect).

More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like China), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. This is sometimes called exploitation.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a relatively cheaper factor of production than is available to factories in richer countries.

Difficulties with PPP comparisons in welfare economics

While using PPP exchange rates for income comparison is an improvement over using market exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another. The PPP method does not account for this. (This is not primarily a flaw in the exchange rate methodology, as cultural and interpersonal differences in utility functions are a more fundamental microeconomic problem.)

A PPP exchange rate varies depending on the choice of goods used for the index (CPI). Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. Indeed, it may be hard to construct equivalent representative bundles for the consumption habits of very different societies. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another, see: consumer price index.

Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the standards of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Even a PPP-adjusted measure of GDP per capita must be used with caution, for all the usual reasons that the GDP figure itself is limited (for instance, its inability to capture the surplus between subjective value and payment price).

For example, in 2002, the nominal GDP per capita in Japan was about US$40,000, while the equivalent PPP into a U.S. goods basket was estimated at $27,000. In the US, GDP per capita was about $36,400 (nominal and real if based on 2002 dollars). This means that the average US citizen could enjoy slightly more consumption than the average Japanese (vastly more if private saving is removed from consumption income). However, it does not necessarily follow, that this implies a "higher standard of living" in the sense of "enjoying life" more; the US has higher crime rates and less social cohesion than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences.

While per-capita income does not take into account inequalities in wealth distribution, neither does the PPP-scaled income.

Clarification to PPP Numbers of the IMF

The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that areas currency. The only time the PPP exchange rate and the market exchange rate can differ is when the GDP number is converted into another currency.

Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: ^*. The PPP exchange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.

Clarification to PPP equalization

PPP equalization fails on many counts. The exchange rate only reflects traded goods in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market.

External links

Explanations from the U. of British Columbia
Disk Lectures Audio lecture with slideshow on foreign exchange rates

Economic indicators | Index numbers | International economics

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