๐ Definition of Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market 'basket of goods' approach. It suggests that exchange rates should adjust to equalize the purchasing power of currencies across countries. In simpler terms, a basket of goods should cost roughly the same in different countries when measured in a common currency.
๐ History and Background
The concept of PPP dates back to the Salamanca School in the 16th century but was popularized in its modern form by Gustav Cassel in the early 20th century. Cassel used PPP to predict exchange rates after World War I. It became a widely discussed topic in international economics, influencing theories of exchange rate determination and international trade.
๐ Key Principles of PPP
- โ๏ธLaw of One Price: This principle states that identical goods should have the same price in all markets if there are no transportation costs or trade barriers.
- ๐Exchange Rate Adjustment: PPP suggests that exchange rates will adjust to reflect differences in price levels between countries.
- ๐Inflation Rate Impact: Differences in inflation rates between countries can affect the relative purchasing power of their currencies and, therefore, exchange rates.
๐งฎ Absolute vs. Relative PPP
- ๐ฏAbsolute PPP:
- ๐ [Geography Emoji] Asserts that exchange rates should equal the ratio of the price levels.
- $S = \frac{P_1}{P_2}$ where $S$ is the spot exchange rate, $P_1$ is the price level in country 1, and $P_2$ is the price level in country 2.
- ๐Relative PPP:
- ๐งญ [Navigation Emoji] States that the change in exchange rates should equal the difference in inflation rates.
- $\% \Delta S = \% \Delta P_1 - \% \Delta P_2$ where $\% \Delta S$ is the percentage change in the spot exchange rate, $\% \Delta P_1$ is the percentage change in the price level in country 1, and $\% \Delta P_2$ is the percentage change in the price level in country 2.
๐ Real-world Examples
Let's explore some practical applications of PPP:
| Example |
Description |
| The Big Mac Index |
๐ Published by The Economist, this index compares the price of a Big Mac hamburger across different countries. It's an informal way to assess whether currencies are at their 'correct' level. For example, if a Big Mac costs $5 in the US and the equivalent in local currency costs $6 in another country, it might suggest that the other country's currency is undervalued. |
| International Comparisons Program (ICP) |
๐ The ICP, led by the World Bank, collects price data to calculate PPP exchange rates. These are used to convert GDP and other economic indicators into a common currency, allowing for more accurate comparisons of living standards between countries. |
| Adjusting GDP for PPP |
๐ฐ When comparing the GDP of different countries, economists often use PPP-adjusted GDP. This adjusts for the differences in the purchasing power of currencies, providing a more accurate picture of the relative size and economic well-being of different economies. |
๐ก Conclusion
While PPP is a valuable theoretical concept, it's important to remember that it's a simplified model. In the real world, factors like transportation costs, trade barriers, and non-tradable goods can cause deviations from PPP. Nevertheless, understanding PPP is crucial for analyzing exchange rates, comparing economic performance across countries, and making informed decisions in international business and finance.