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Purchasing Power Parity

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Purchasing Power Parity

Imagine you want to buy a new textbook for your next class. Do you buy it in person, or go online and buy from a seller who might be anywhere in the world? Imagine it's available at a nearby store for $50, but the same new book is also available from a seller in another country, and the shipping is free! That seller's price is only twenty-five units of that country's currency. Twenty-five is only half of fifty, so the mail-order book is cheaper, right?

Of course not! Whether this is a good idea or not depends entirely on the exchange rate between the two currencies.

What might you expect the exchange rate to be in this situation? What would you do if you knew that the exchange rate equated to twenty-five units of the other currency with less than $50? That would mean your money gives you more purchasing power in the other currency! You may not realize it, but you just calculated purchasing power parity!

The next time you are considering buying something in another currency, you're going to be glad you read this explanation and learned all about Purchasing Power Parity!

Purchasing Power Parity (PPP) definition

Purchasing power is what money gives us--the ability to acquire goods and services for consumption. From one country to the next, does our purchasing power go equally far? That depends on the exchange rate between the two currencies. We might find it useful to start from a place where prices are equal everywhere, where the cost of an item in US dollars is the same as converting those US dollars into Euros and purchasing the same item.

If the purchasing power that can buy a basket of goods in one country is what also buys that exact same basket of goods in another country, then those countries are said to be in Purchasing Power Parity. This means that they have an exchange rate between their currencies that makes their prices equal to one another, for the same items or basket of items.

Purchasing power parity is the exchange rate that would make the purchasing power in one country equal to that of another country with a different currency. It is calculated as the ratio between the prices in the different currencies of the same item or basket of goods.

You can think of it as the nominal exchange rate that allows someone to acquire the same amount of goods and services in the two different counties with exactly the same amount of purchasing power.

PPP calculates this "reference point" exchange rate by comparing how much it would cost to purchase the same basket of goods in one country compared to the other. Any exchange rate above or below this suggests that one of the currencies is overvalued or undervalued. This creates an opportunity for people to shift purchases from one country to another, where they can acquire the same goods for less money, because the exchange rate gives them more purchasing power.

Purchasing Power Parity formula

The following formula is used to compute the purchasing power parity (PPP):

Let us understand this formula with the help of an example. Suppose the price of a pen in the United States is $2, and the price of the same pen denominated in tenge, the currency of Kazakhstan, is ₸37.

Then, we can calculate the PPP exchange rate as:

This tells us that the exchange rate that would give us parity on the price of pens would be when there are exactly ₸18.5 per $1. At this exchange rate, the purchasing power is equated. At a higher or lower rate, one location offers greater purchasing power than the other.

If the prices used in the formula are actually the economy-wide price, or the price of the "market bundle," then the PPP exchange rate tells us about purchasing power in the entire economy. It indicates that one currency may itself be under- or overvalued relative to the other currency. Since the actual currency exchange rate is higher than 18.5, we might conclude that the Kazakhstan tenge is undervalued or the US dollar is overvalued.

Purchasing Power Parity example

Let's consider the cost of a Big Mac in the US using dollars and in the UK using British pounds.

The price of a Big Mac in the UK is £3.39. We denote this as PUK = £3.39.

The price of a Big Mac in the US is $5.71. Let's denote this as PUS = $5.71.

The actual exchange rate at the same point in time is = 0.79. That means $1 equals £0.79.

Now, we get the PPP exchange rate by dividing the price of the Big Mac in the UK by the price of the Big Mac in the US.

That is, 0.59 British pounds per US dollar is the exchange rate that makes these prices equal.

This means that for you to be able to buy the same Big Mac in the UK and the US with the same purchasing power, the exchange rate would have to be 0.59. Now, by comparing the actual exchange rate, which is 0.79, with the PPP exchange rate, we see that actual exchange rate is above the PPP. Specifically, $1 can be exchanged for 33% more British pounds than would be the case under parity.

This is only looking at a basket of one good, but if we were comparing the aggregate price level, we conclude that the British pound is undervalued by 33%. It suggests that purchases are cheaper in the UK than in the US because of the undervalued currency.

The Economist has developed the Big Mac Index, which tracks the PPP as measured by the price of a Big Mac in different countries.

Purchasing Power Parity theory

The purchasing power parity theory indicates that the nominal exchange rate between two countries' currencies is equal to the proportion of the countries' price level. It is an economic theory that suggests that the difference in the price level for the same basket of goods between two countries is what drives the equilibrium exchange rate between countries.

This price level can be considered a general price index made up of a different basket of goods and services. For example, in the United States, the consumer price index (CPI) is the price level of a different basket of goods.

One of the main underlying principles of the purchasing power parity is a concept known as "the law of one price." The law of one price is the idea that other things being equal, identical items sold on a worldwide market should have the same price. Goods and services that can be comparable in value and the equality they offer to customers will tend to converge towards the market equilibrium, resulting in the same prices for both countries.

Importance of Purchasing Power Parity

Purchasing power parity is critical for developing relatively reliable economic data that can be used to evaluate the market situations of various nations across borders.

For example, purchasing power parity is often used to check the difference between countries' nominal GDPs. Because purchasing power varies from country to country, the figure for GDP based on purchasing power parity is often different from nominal GDP.

Additionally, as there is a difference in purchasing power from country to country, it gives insight into the possible overvaluation or undervaluation of a country's currency. This is significant because currencies that are over or undervalued in terms of purchasing power parity (PPP) are likely to adjust over time, resulting in serious economic consequences as well as long-term swings in the currency's value.

For example, a local currency that PPP has assessed to be highly overpriced might be predicted to fall in value relative to frequently traded currencies such as the United States dollar over time.

Limitations of Purchasing Power Parity

Although the purchasing power parity theory helps provide a reference point for understanding changes in exchange rates, it has some limitations. Firstly, limitations can arise due to the difficulty in evaluating the same basket of goods in two countries. Even the same goods may actually be different because of differences in natural assets and cultural differences.

Second, people in two different countries can have different utility functions for the same basket of goods and therefore different consumption patterns. If their demand is significantly higher or lower, it may not be reasonable to expect the purchasing power to reach parity.

Third, many goods are also not traded easily, and even tradeable goods are not always perfect substitutes when they are produced in different countries. In particular, taxes and tariffs are not included, which are important because separate states' sales taxes can change the prices of commodities and services between nations and independent territories.

Below, we discuss four additional limitations of PPP: transportation cost, competition, cost of input, taxes.

Transportation Cost

When explaining trade between countries, PPP does not consider the transportation cost of moving goods between nations. It is much more expensive to bring goods from China to the US than from the UK to the US. This makes imported goods more expensive, which is not necessarily reflected in the exchange rate.

Competition

Some markets are less competitive, which means that more companies can charge higher prices. On the other hand, the companies at home don't have monopolistic power and resort to charging lower prices for the same good.

Cost of Inputs

For the basket of goods and services that we are trying to analyze, the price reflects other costs that are different for two different countries. Examples of these costs include utility bills and labor costs.

Taxes

Companies don't always pay the same taxes, which means that the price of goods will not be the same in other countries, hence providing a drawback for the PPP theory. In places where companies pay higher taxes per output sold, you would expect the output price to be much higher.

Types of Purchasing Power Parity

The two main types of purchasing power parity include: absolute purchasing power parity and relative purchasing power parity.

Absolute Purchasing Power Parity

Absolute purchasing power parity suggests that the two countries' price ratio is equal to the equilibrium exchange rate between the two countries. In other words, the exchange rate between the two countries is reflected in the basket of goods you are buying, and the amount of goods in the basket you get is the same for both countries.

In the presence of absolute purchasing power, there are no barriers such as distance or tariffs that would have an influence on the prices of the goods. It implies that the costs of the same basket of merchandise in various nations should be equivalent when considering other costs.

An example of absolute purchasing power parity would be the price of tacos in the US and Mexico. If tacos cost $7 in the US, according to absolute purchasing power parity, the price of tacos would be the equivalent of $7 in Mexico after having exchanged the US dollars for Mexico pesos.

Relative Purchasing Power Parity

Relative purchasing power parity is when the ratio of the changes in the price level in two different countries is proportional to the change in the equilibrium exchange rate. According to relative purchasing power parity, when there are differences in the price levels between two countries, these differences will cause the exchange rate between two countries to change. The new exchange rate, influenced by the differences in the price level, will converge towards a new equilibrium point where price levels are at the same level.

Relative purchasing power parity is useful in explaining the long-run dynamics between price levels and the exchange rate. It suggests that the two will equal each other over the long run.

To better understand the relative purchasing power parity, assume that the USA and the UK are buying and selling with zero inflation differences initially. Now imagine that the USA has a 9 percent inflation price, and the UK has a 5 percent inflation rate.

According to relative purchasing power parity, the 4 percent difference between these two countries will cause a 4 percent change in the exchange rate. In such a case, the British Pound will devalue by four percent to account for the difference in the price level between the US and the UK. After the British pound has been devalued by 4 percent, the new exchange rate will reflect the same price levels in the US and the UK.

Purchasing Power Parity - Key Takeaways

  • Purchasing power parity is the exchange rate that would make the purchasing power in one country equal to that of another country with a different currency. It is calculated as the ratio between the prices in the different currencies of the same item or basket of goods.
  • The PPP formula is:
  • Purchasing power parity is critical for developing relatively reliable economic data that can be used to evaluate the market situations of various nations across borders.

  • There are four key limitations of PPP: transportation cost, competition, cost of input, taxes.

  • Absolute purchasing power parity predicts that the ratio of price levels will equal the exchange rate, and relative purchasing power parity predicts that the ratio of changes in the price levels will equal the exchange rate.

"The Big Mac index," The Economist. Feb. 2, 2022. https://www.economist.com/big-mac-index

Frequently Asked Questions about Purchasing Power Parity

Purchasing power parity is the nominal exchange rate that would make the purchasing power in one country equal to that of another country with a different currency. It is calculated as the ratio between the prices in the different currencies of the same item or basket of goods.  

The formula that is used to compute the PPP exchange rate is the price of the basket of goods in currency A divided by the price of the same basket of goods in currency B.

Purchasing power parity is critical for developing relatively reliable economic data that can be used to evaluate the market situations of various nations across borders. 

Suppose the price of a pen in the United States is $2, and the price of the same pen denominated in tenge, the currency of Kazakhstan, is ₸37.  Then the PPP exchange rate would be 18.5 tenge per dollar. This is the exchange rate that equates purchasing power in the two countries.

According to relative purchasing power parity, it is the ratio of changes in prices, rather than the ratio of price levels, that determines the exchange rate between two countries' currencies.

Final Purchasing Power Parity Quiz

Question

What is purchasing power parity?

Show answer

Answer

Purchasing power parity is the nominal exchange rate that would make the purchasing power in one country equal to that of another country with a different currency. It is calculated as the ratio between the prices in the different currencies of the same item or basket of goods.  

Show question

Question

What is the use of PPP?

Show answer

Answer

Purchasing power parity (PPP) is used to evaluate the current exchange rate between two countries. Any exchange rate above or below the PPP suggests that one of the currencies is overvalued or undervalued.

Show question

Question

Why is purchasing power parity important?


Show answer

Answer

Purchasing power parity is critical for assessing the global market opportunities and currency under- or overvaluations.

Show question

Question

What is an example of purchasing power parity?


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Answer

Suppose, the price of a pen in the United States is $2 USD and the price of the same pen in Turkey is 17 TL.

Then, PPP = TL price / USD price = 17 TL / 2 USD = 8.5 TL per USD.


Thus, there is exact purchasing power parity in pens if the exchange rate is $1 = 8.5 TL.

Show question

Question

If PPP for a Big Mac between the US and the UK was 0.59, and the exchange rate was 0.79, what does it mean for the British Pound and the US dollar? Also, in which country is the Big Mac cheaper? 

Show answer

Answer

Since the actual exchange rate (0.79) is higher than the PPP exchange rate (0.59), we know that either the British Pound is undervalued or the US dollar is overvalued. Either way, the Big Mac is cheaper in the UK.

Show question

Question

Explain the purchasing power parity theory.

Show answer

Answer

The purchasing power parity theory indicates that the exchange rate of two countries' currencies is equal to the proportion of the countries' price level. It is an economic theory that suggests that the difference in the price level for the same basket of goods between two countries is what drives the equilibrium exchange rate between countries. 

Show question

Question

What is one of the main underlying principles of the purchasing power parity theory?

Show answer

Answer

One of the main underlying principles of the purchasing power parity is a concept known as "the law of one price."

Show question

Question

What is the law of one price?

Show answer

Answer

The law of one price is based on the idea that other things being equal, identical items sold on a worldwide market should have the same price. Goods and services that can be comparable in value and the equality they offer to customers will tend to converge towards the market equilibrium, resulting in the same prices for both countries. 

Show question

Question

What are the limitations of PPP?

Show answer

Answer

There are four main types of limitations of PPP: transportation cost, competition, cost of input, taxes.

Show question

Question

Explain how transportation cost limits PPP.

Show answer

Answer

When explaining trade between countries, PPP does not consider the transportation cost of moving goods between nations. It is much more expensive to bring goods from China to the US than from the UK to the US. This makes imported goods more expensive, which is not necessarily reflected in the exchange rate.

Show question

Question

Explain how competition limits PPP.

Show answer

Answer

Some markets are less competitive, which means that more companies can charge higher prices. On the other hand, the companies at home don't have monopolistic power and resort to charging lower prices for the same good. 

Show question

Question

Explain how cost of input limits PPP.

Show answer

Answer

The basket of goods and services that we are trying to analyze are produced using inputs that are different costs in the two different countries, such as utility bills and labor costs. 

Show question

Question

Explain how taxes limit PPP.

Show answer

Answer

Companies don't always pay the same taxes, which means that the price of goods will not be the same in other countries, hence providing a drawback for the PPP theory. In places where companies pay higher taxes per output sold, you would expect the output price to be much higher. 

Show question

Question

What are the two types of purchasing power parity?

Show answer

Answer

The two main types of purchasing power parity include: absolute purchasing power parity and relative purchasing power parity.

Show question

Question

Explain absolute purchasing power parity.

Show answer

Answer

Absolute purchasing power parity suggests that the two countries' proportion of the price level is equal to the equilibrium exchange rate between the two countries. In other words, the exchange rate between the two countries is reflected in the basket of goods you are buying, and the amount of goods in the basket you get is the same for both countries. 

Show question

Question

Explain relative purchasing power parity.

Show answer

Answer

The proportion of the change in the price level of two different countries is proportional to the change in the equilibrium exchange rate. According to the relative purchasing power parity, when there are differences in the price levels between two countries, these differences will cause the exchange rate between two countries to change. The new exchange rate, influenced by the differences in the price level, will converge towards a new equilibrium point where price levels are at the same level.

Show question

Question

You go to purchase a textbook in your country for $17.99. That same book will cost you £13.56 in the UK. The exchange rate is £1 per $1.23. What is the PPP? Is the USD under or overvalued?

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Answer

$1.33 per £1, overvalued.

Show question

Question

Calculate the PPP of french fries when they cost $2.87 in the US and £1.94 in the UK.

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Answer

$1.47 per £1

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Question

The exchange rate for the South African Rand per USD is 16:1. If Joe buys a cookie in South Africa for 15 Rand and the cookie costs $0.99 in the US, what is the PPP? Is the Rand overvalued?

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Answer

15.15. The Rand is undervalued.

Show question

Question

A table costs 100,000 Rupees. In South Africa the same table costs 31,000 Rand. What is the PPP?

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Answer

3.23

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Question

1 month of childcare costs $2000. It costs £1,300 in the UK. What is the PPP?

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Answer

1.54

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Question

If the PPP is 0.57 per dollar but the exchange rate is 0.84 per dollar, what does this suggest?

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Answer

That the other currency is undervalued.

Show question

Question

When the PPP and the exchange rate are equal we have...

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Answer

Exchange rate equilibrium.

Show question

Question

What is a basket of goods?

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Answer

A collection of goods used to measure prices in the economy.

Show question

Question

What if the exchange rate is lower than the PPP?

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Answer

The currency is undervalued.

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Question

What is the aggregate price level?

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Answer

The average price level of all goods and services taken into account.

Show question

Question

The concept that a pair of scissors sold in Australia should be sold for the same price in Wales is called...

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Answer

The Law of One Price.

Show question

Question

What does PPP have to do with GDP?

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Answer

PPP can be used to check a country's real GDP compared to its nominal GDP.

Show question

Question

It is better for your currency to be overvalued.

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Answer

An overvalued currency can cause the currency to adjust to a more accurate reflection of the market and this can cause economic consequences and be destabilizing.

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Question

How is it possible that one basket of goods accurately reflects one population but not another?

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Answer

Different cultures and populations have different levels of utility for the same basket of goods.

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Question

Why do we need to take taxes and tariffs into account when evaluating PPP?

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Answer

Because the fees vary depending on the nation and the tax burden. Different country's requirements affect the price that the consumer will pay.

Show question

Question

If you live on a teeny tiny island in the middle of the Atlantic, why might PPP not be accurate when evaluating the price of your goods?

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Answer

PPP does not take in the cost of transportation that the consumer has to bear, so if you live in a hard-to-reach place you will have to make up for the transport costs.

Show question

Question

In Alaska, crab cakes are $1. In Germany they are 5 euros, even though the exchange rate is only $1.02 per euro. What is a limitation PPP faces in this case?

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Answer

Cost of inputs. Crab is significantly more expensive in Germany than it is in Alaska, at its source.

Show question

Question

If the amount of goods in the basket you get is the same for both countries and the basket reflects the exchange rate, you have...

Show answer

Answer

Absolute Purchasing Power Parity.

Show question

Question

Relative purchasing power parity is useful in explaining...


Show answer

Answer

 The long-run dynamics between price levels and the exchange rate.

Show question

Question

What is the CPI?

Show answer

Answer

The Consumer Price Index measures the average price of a basket of goods.

Show question

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