Overview
Purchasing Power Parity (PPP) is an economic theory that compares different countries’ currencies through a ‘basket of goods’ approach. It suggests that in the long run, exchange rates should move towards levels that would equalize the prices of an identical basket of goods and services in any two countries.
Key Concepts
The core idea of PPP is that identical goods should cost the same everywhere when prices are expressed in a common currency. This is often illustrated using the Big Mac Index. If a Big Mac costs $5 in the US and £4 in the UK, the implied PPP exchange rate is $1.25 per £.
Deep Dive
PPP theory has two main versions:
- Absolute PPP: The price of a specific good or service should be the same in all countries.
- Relative PPP: The exchange rate between two currencies should reflect the difference in inflation rates between the two countries.
Relative PPP is generally considered more robust and empirically supported than absolute PPP.
Applications
PPP is used for several purposes:
- International Comparisons: Adjusting GDP and other economic indicators to allow for more accurate comparisons of living standards and economic output across countries.
- Exchange Rate Forecasting: As a long-term benchmark for exchange rate movements.
- Economic Policy: Informing decisions related to trade and investment.
Challenges & Misconceptions
PPP is not a perfect predictor of short-term exchange rates due to several factors:
- Non-tradable goods: Prices for services like haircuts or rent vary significantly and aren’t easily arbitraged.
- Trade barriers: Tariffs, quotas, and transportation costs affect prices.
- Market imperfections: Differences in taxes, regulations, and consumer preferences.
A common misconception is that PPP holds true in the short run for all goods.
FAQs
What is the ‘basket of goods’?
It’s a representative selection of goods and services commonly consumed in a country, used to calculate price levels and PPP exchange rates.
Is PPP the same as the market exchange rate?
No. The market exchange rate is determined by supply and demand for currencies, while the PPP exchange rate is based on relative price levels.