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Purchasing Power Parity

The Purchasing Power Parity (PPP) is a theory of exchange rate determination. It asserts (in the most common form) that the exchange rate change between two currencies over any period of time is determined by the change in the two countries' relative price levels. Because the theory singles out price level changes as the overriding determinant of exchange rate movements it has also been called the 'inflation theory of exchange rates'.

During the 1990s PPP has attracted an enormous amount of interest. Presumably driven by the disbelief that such an intuitively appealing proposition about exchange rate behavior had found little support in the data, researchers have embarked in a "search" for PPP using increasingly sophisticated time series methods. The early 1990s have seen a proliferation of studies testing for PPP over the long-run either by testing whether nominal exchange rates and relative prices move together (co integrate) or by testing whether the real exchange rate has a tendency to revert to a stable equilibrium level over time (is stationary).

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.

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. In other words, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency.

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 the People's Republic of 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 the People's Republic of 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.

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.). 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.

The main reasons why PPP does not perfectly reflect standards of living are because: a) PPP numbers can vary with the specific basket of goods used, making it a rough estimate; b) Preferences and choices can vary from country to country; c) International competitiveness is mainly affected by the exchange rate and not by PPP; d) Differences in quality of goods are not sufficiently reflected in PPP.

The goods that the currency has the "power" to purchase are a basket of goods of different types: 1) Local, non-tradable goods and services (like electric power) that are produced and sold domestically; 2) 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. Conversely, category 2 products tend to trade close to the currency exchange rate.

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 and domestically produced rice.

If there are non-tradable goods, one can no longer apply the law of one price in deriving PPP. However, as long as there are no relative price changes between traded goods and non-traded goods, relative PPP will hold. In other words, if the law of one price applies to traded goods, the real exchange rate is determined by the relative price of traded goods in the two countries.

On the other hand, International Fisher Effect is an economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.

Factors which affect a country's money supply and/or demand have powerful effects on the exchange rate for its currency. Monetary developments influence the exchange rate both by changing interest rates and by changing people's expectations about future exchange rates. Moreover, expectations about future exchange rates are influenced by expectations about the future purchasing power of a country's money, which itself reflects output price developments that are themselves influenced by changes in money supply and/or demand. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behavior of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. However, this process can take years.

In the decade of the 1990s, the United States emerged as the global leader, both economically and politically. Interest rates and inflation remained low through the end of the decade. The "strong dollar" policy of the US Treasury was consummated by the late 1990s, and indeed contributed a bit to the crises that, beginning in 1997, hit