Purchasing Power Parity

 

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The Context 

This note is targeted at queries which arise while we conduct our course with MPs on topics related to Economics, Budget and Governance.

 

Key aspects 

   1. Concept and rationale

   2. Difficulties in measurement and comparisons

   3. Different measures of PPP and their criticisms

 

Requested By

A first timer MP from Tamil Nadu

 

Length

This has to be very brief. Approx 500 words (one e mail meesage screen)

 

Due date

8th Mar 2008

 

 

 

Response

 

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Concept

 

Let us start with a simple and familiar example. Two years back, a dollar could be used to buy 45 rupees. Today, it can buy only 39 rupees. In other words, the value of dollar fell compared to the rupee, while its value might have increased w.r.t some other currency. What explains these contrasting changes? There are many models to explain how exchange rates are determined, each highlighting some of the many factors at work.

The simplest of them is called purchasing power parity. This theory states that a unit of any given currency should be able to buy the same quantity of goods in all counties. Many economists believe that purchasing power parity describes the forces that determine exchange rates in the long run.

 

 

Purpose

 

The concept of purchasing-power parity (PPP) has two applications: it was originally developed as a theory of exchange rate determination, but it is now primarily used to compare living standards across countries.

 

Rationale

 

The theory of purchasing power parity is based on the priniciple that a good must sell for the same price in all locations. Otherwise, there would be opportunities for profit left unexploited. For example, a person can buy a pen for Rs 5 in Delhi and then sell it in Bangalore for Rs 7, making a profit of Rs 2 per pen from the difference in price. The process of taking advantage of difference in prices in different marketsis called arbitrage. In this example, as people took advantage of this arbitrage opportunity, they would increase the demand for pen in Delhi and increase the supply of pen in Bangalore. Thus the price of pen will rise in Delhi and fall in Bangalore. This process will continue until the prices are same in the two markets.

 

Let us apply this same theory to the inetrnational markets. If a dollar (or any other currency) could buy more pens in United States than in England, international traders could make profit by buying pens in United States and selling it in England. This would drive up the price of pen in US and drive it down in UK. Conversely, if a dollar could buy more pens in UK than that in US, traders could buy pens in UK and sell it in US which could have the price effect as described above. This leads to the theory of purchasing power parity. According to this, a currency must have the same purchasing power in all countires. As the name suggests, parity means equality, and purchasing power refers to the value of money. Purchasing power states that a unit of all currencies must have the same real value in every country.

 

HOW IS PPP CALCULATED?

 

The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consume very different sets of goods and services, making it difficult to compare the purchasing power between countries.

 

Difficulties in measurement and comparisons

 

Purchasing power parity provides a simple model of how exchange rates work. This theory works well for many economic phenomena. Yet this theory is not completely accurate. It means that exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time. There are two main reasons why this theory does not always hold good.

First, there are many goods which are not easily traded. In such cases, arbitrage would probably be too limited to eliminate the difference in prices. Thus, the deviation from purchasing power might persist.

Second, Even tradable goods are not always perfect substitutes when they are produced in different countries. For example, some consumers prefer Newport jeans and others prefer Lee Cooper. Moreover, consumer interest changes with time. If Lee Cooper suddenly becomes popular, increase in demand for Lee will go up. As a result, a dollar might then buy more Lee jeans in United States than in India. But despite the difference in prices in the two markets, there might be no opportunity for arbitrage because consumers do not view the two jeans as equivalent.