How Well Does the Theory of Purchasing Power Parity Explain Exchange Rates?
With purchasing power parity, exchange rates between different currencies can be easy to calculate. It allows you to compare the purchasing power of various world currencies against each other so that you can buy the same amount of goods in each country.
Many government agencies use purchasing power parity (PPP) to compare the outputs of countries with different exchange rates. The theory plays a vital role in evaluating the living standards and economic performance between two or more countries.
So how does the purchasing power parity explain exchange rates? This guide explores the basics of PPP theory and its impact on currency exchange rates.
What is Purchasing Power Parity (PPP)
The PPP theory states that the exchange rate between two currencies is in equilibrium when their purchasing powers are the same in both countries.
In other words, the exchange rates between the two countries equal the ratio of the countries’ price level of a particular basket of goods and services.
The price levels are determined by the basket of goods or services available in the two countries and do not suffer distortions from excise duties or transportation costs.
The general increase in prices in one country won’t seriously impact the PPP because inflation is inversely proportional to exchange rates.
As inflation increases, the exchange rates must decrease to maintain an equilibrium and return to PPP. You can use the PPP to estimate a product’s price in another country.
The Purchasing Power Parity (PPP) as the Law of One Price
The “law of one price” is the basis for PPP. Without transportation and costs, prices of identical goods in two countries should be equal when expressed in the same currency.
If the USD/CAD exchange rate is 1.20, then a furniture set priced at $500 in the United States should cost C$600 in Canada. If it costs C$550, most Americans will buy their furniture sets in Canada.
They will have to buy the Canadian dollar and sell their U.S. dollars, strengthening the Canadian dollar and weakening the U.S. dollar. The Candian dollar’s strength will force the Canadian furniture price to rise to C$600 to re-establish an equilibrium.
For the law of one price to qualify, the following requirements must be upheld.
- The markets for goods and services in both countries must be competitive
- Barriers of trade, transportation costs, and other transaction costs are significant
- The law only applies to tradable goods and not immobile goods like houses
Versions of Purchasing Power Parity
There are two versions of Purchasing Power Parity (PPP): Absolute and Relative PPP.
The example described above illustrates absolute PPP, which is the equalization of price levels between countries. You can express absolute PPP mathematically by dividing the price level in one country by the price level in another country.
In that case, dividing the Canadian price level by the American price level will give you the Canada-to-U.S. exchange rate. Any distortion of the equation will exert pressure on the exchange rate until when the equation attains an equilibrium.
The relative PPP focuses on the rate of price change rate, also referred to as inflation rates. This version states that a currency’s appreciation rate equals the difference in inflation rates between the home and foreign countries.
For example, suppose Canada has an annual inflation rate of one percent and the United States three percent. In that case, the U.S. dollar will depreciate by two percent every year against the Canadian dollar.
The relative PPP only applies when significant inflation differences exist between two different currencies. It’s the dynamic version of the absolute PPP.
Actual Impact of the PPP on Exchange Rates
Does the purchasing power parity affect exchange rates in the short term? No. PPP only has a long-term effect on exchange rates since long-term economic trends determine inflation, changing the exchange rates.
For the PPP to affect the exchange rates significantly, it can take around 4-10 years. Some factors that can impact the exchange rates in the short term include political and economic news, like the changes in interest rates and money supply.
How to Calculate Purchasing Power Parity (PPP)
The easiest way to calculate the PPP between two countries is by comparing the prices for a ‘standard’ product in both countries. However, there are many sophisticated versions for measuring the PPP that look at many goods and services.
The main challenge for calculating the PPP is that many people in various countries consume different goods and services. That makes it difficult to evaluate the purchasing power between the countries. So, what’s the simplest method for calculating the PPP.
Purchasing Power Parity Formula
The PPP is an economic indicator used to determine exchange rates between countries to exchange goods and services for the same amount.
So, here is the purchasing power parity formula.
- ‘S’ is the exchange rate
- ‘P1’ is the total cost of a basket of goods in country A
- ‘P2’ is the total cost of a basket of goods in country B
Here is an example of a PPP calculation.
Let’s assume that the U.S. dollar equals 50 Indian rupees ($1 = 50), and an American visited the South Asian country for the first time. He then purchases 10 burgers for Rs 100 (10 Rs per burger) and thinks the burgers are cheaper in India than in the U.S.
When in the United States, the American buys a similar burger for $3. Based on the exchange rate, $3 = 150 Indian rupees, which means 15 burgers in India. So, the PPP ratio for the exchange of a burger is $3 = 100 Indian rupees ($1 = 33.33).
The purchasing power parity plays a significant role in the global economy, especially when it comes to exchanging goods and services from different countries. You can exchange goods and services of similar amounts with the same amount of expenses. Finally, PPP helps countries compare their outputs with each other.