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Purchasing Power Parity

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Introduction, ppp in the short run, empirical advancements, random walk, cointegration section.

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Essay on Purchasing Power Parity

The PPP (Purchasing Power Parity) hypothesis illustrates the relationship which exists between prices and exchange rates in the economy. PPP can be categorized into absolute PPP and relative PPP. Absolute PPP is where purchasing power parity is defined as the ratio of two countries price levels. On the other hand, relative PPP, in a base period, the product of the stated exchange rates, is a ratio of the price indices between countries. The testing of this theory began in 1970 and has continued since due to occurrences such as the development of the economic theory. To apply PPP, we have to know the conversion factor that is used in the transfer of data when dealing with different currencies. In the account’s framework, this data ranges to high expenditure from the GDP. With PPP and its theories such as the mainly index- number theory, and comparison of inter-country GDP, data conversion can be highly boosted. (Dept., 2020)

Even though PPP is not supported by any economists, it has many supporters who use it in the case of calculating exchange rates. PPP also involves equilibrium exchange rates. An unmanaged exchange rate system is a form of short-run equilibrium exchange rate. In the case where the fixed exchange rate would produce balances of payments at equilibrium, we refer to that as long-term equilibrium exchange rate.

Problems Facing the Verification of Purchasing Power Parity Hypothesis

Assumptions

The PPP hypothesis makes a number of unlogic assumptions which becomes a problem. As due to these assumptions such as there does not exist transaction costs, this hypothesis does not hold. This is because in an economy where transaction costs exist, real exchange rates deviate from the PPP which causes a fluctuation in how international goods move. Not all goods and services can be traded internationally. This is a problem as PPP is under the assumption that all goods and services can be exchanged internationally.

Trade Restrictions

As stated earlier, the purchasing power parity hypothesis should be maintained at an equilibrium state. In some countries, trade restrictions are unadorned making a country to participate in more exports than imports. This causes the country’s currency exchange value to go above the PPP. This becomes a limitation in the verification of the PPP hypothesis. (Coakley, Flood & Taylor, 2004)

Speculation

Speculation in a market is where traders hold back goods in anticipation for a rise in the prices in the future. Traders may also dispose all goods at once in speculation that prices may fall. The exchange value of a country is supposed to be at per with the PPP. In the case where a country’s currency does not support speculation in the foreign exchange market, in the case of speculation, the exchange rate falls below the PPP making it difficult to verify this hypothesis.

Government Intervention

When the government intervenes in the foreign exchange market, by putting up tariffs and setting prices for imports; prices bid up rising above the PPP in the case of foreign exchange. This is because the government wants to benefit from foreign exchange by getting funds for government expenditure. This makes the verification of the purchasing power parity hypothesis difficult.

Relativity in Prices

Prices may change relatively in a country. This indicates changes taking place in the economy. This causes a deviation from the set foreign exchange rate to the relative PPP.

In the case where the inflation of a country increases, the purchasing power of a country’s currency reduces. This forces a country to reducing their selling price below the real price of goods. This in turn lowers the country’s currency exchange value in the foreign exchange market below the PPP. This variation makes it difficult to verify the effectiveness of the purchasing power parity hypothesis.

Cost of Transport

There exists a difference in how imported goods are sold and those that have been produced locally. This brings about varying transportation costs. For imported goods, the cost of transportation is high while the cost of transporting locally manufactured good is low. Since countries have to consider this while importing or exporting goods, a fluctuation exists in the foreign exchange market causing a rise in the exchange rate above the PPP. This variation makes it difficult for the purchasing power parity hypothesis to hold as there does not exist an equilibrium state.

Capital Movements

Capital is the available resources and funds which are used in starting a business or a production of goods and services. The use of a greater percentage of the available capital causes a fall in a country’s currency purchasing power. This decrease in value causes a relative decrease in exchange rate value causing a fall below the PPP. The absence of a state of equilibrium makes it difficult to verify the effectiveness of the purchasing power parity hypothesis.

Each country taxes its citizens. This is one of the ways in which the government gets its income which is used in projects that would benefit every citizen. Tax rates vary from country to country. This difference in taxes regulates what countries would charge at their borders in the case of either exports or imports. An increase in taxation increase the value of goods and services both locally and internationally. As a result, the exchange rates in a foreign market rise above the PPP. This makes it a problem to test the validity of the purchasing power parity.

Non-Profitable Services

These are services mainly offered by the government as they are essential but non-profitable. The government uses funds received from taxation. This causes an imbalance in the economy as capital is used but there is no profit received. This causes the value of currency in the foreign exchange market to fall making it unprofitable for exports. As a result, the exchange rates fall below the PPP. This becomes a problem as due to absence of an equilibrium state, it is difficult to verify the usefulness of the power purchasing parity hypothesis.

Dept., I. (2020). The Purchasing-Power-Parity Theory of Exchange Rates: A Review Article. Retrieved 17 December 2020, from  https://www.elibrary.imf.org/view/IMF024/15467-9781451956436/15467-9781451956436/15467-9781451956436_A001.xml?language=en&redirect=true

Coakley, J., Flood, R., & Taylor, M. (2004). Purchasing power parity and the theory of general relativity: the first tests. Retrieved 17 December 2020, from  https://www.cass.city.ac.uk/__data/assets/pdf_file/0008/29078/Purchasing_Power_Parity.pdf

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What Is Purchasing Power Parity?

• Calculation

How PPP Is Used

• Pairing PPP and GDP
• Drawbacks of PPP

The Bottom Line

• Macroeconomics

What Is Purchasing Power Parity (PPP), and How Is It Calculated?

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Purchasing power parity (PPP) is a popular macroeconomic analysis metric used to compare economic productivity and standards of living between countries.

PPP involves an economic theory that compares different countries' currencies through a "basket of goods" approach. That is, PPP is the exchange rate at which one nation's currency would be converted into another to purchase the same and same amounts of a large group of products.

According to this concept, two currencies are in equilibrium—their currencies are at par —when a basket of goods is priced the same in both countries, taking into account the exchange rates.

Key Takeaways

• Purchasing power parity is a popular metric used by macroeconomic analysts that compares different countries' currencies through a "basket of goods" approach.
• PPP allows economists to compare economic productivity and standards of living between countries.
• Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
• Some feel that PPP does not reflect reality due to differences in local costs, taxes, tariffs, and competition.

Calculating Purchasing Power Parity

The relative version of PPP is calculated with the following formula:

 S = P 1 P 2 where: S =  Exchange rate of currency  1  to currency  2 P 1 =  Cost of good  X  in currency  1 \begin{aligned} &S=\frac{P_1}{P_2}\\ &\textbf{where:}\\ &S=\text{ Exchange rate of currency }1\text{ to currency }2\\ &P_1=\text{ Cost of good }X\text{ in currency }1\\ &P_2=\text{ Cost of good }X\text{ in currency }2 \end{aligned} ​ S = P 2 ​ P 1 ​ ​ where: S =  Exchange rate of currency  1  to currency  2 P 1 ​ =  Cost of good  X  in currency  1 ​ 

To make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. However, the one-to-one comparison is difficult to achieve due to the sheer amount of data that must be collected and the complexity of the comparisons that must be drawn.

To help facilitate this comparison, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP) in 1968.

Users of PPP

• With this program, the PPPs generated by the ICP have a basis in a worldwide price survey that compares the prices of hundreds of various goods and services. Thus, the program helps international macroeconomists estimate global productivity and growth.

• Every few years, the World Bank releases a report that compares the productivity and growth of various countries in terms of PPP and U.S. dollars.  Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use weights based on PPP metrics to make predictions and recommend economic policy.

Their recommendations can have an immediate short-term impact on financial markets.

• Some forex traders use PPP to find potentially overvalued or undervalued currencies. And investors who hold stocks or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus on their investment.

The PPP exchange rate is used to convert the local currency of a target nation into a common currency applicable to all nations. Normally, this common currency is the US dollar or what's called the International dollar, a currency designed to serve as a baseline.

Pairing PPP With Gross Domestic Product

In contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of the goods and services produced within one country. Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation.

Some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily compared between countries with different currencies.

To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5.

In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany when buying it with the euro.

Drawbacks of Purchasing Power Parity

Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s ( MCD ) Big Mac hamburger across many countries. Its study produces the famed Big Mac Index. In "Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.

Transport Costs

Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.  

Tax Differences

Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.

Government Intervention

Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.  

Non-Traded Services

The Big Mac's price includes input costs that are not traded, such as insurance, utility costs, and labor costs . Therefore, these expenses are unlikely to be at parity internationally .

Market Competition

Goods might be priced higher deliberately in a particular country. In some cases, higher prices result because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.

What Is PPP?

Purchasing power parity is the exchange rate at which the currency of one nation must be converted into the currency of another so that the same products and services can be purchased in each country.

Why Is PPP Important?

PPP is an important metric because it provides a way to compare levels of growth and standards of living in various nations, each of which has its own currency.

Which Country Ranks Lowest in PPP and GDP?

For 2022, the value of Burundi's PPP/GDP metric was the lowest out of 177 countries evaluated.

While it's not a perfect measurement tool, purchasing power parity does allow for the possibility of price comparisons between countries with differing currencies. It's used by many economists, international organizations, foreign exchange traders, and investors to examine economic productivity and the value of investments.

International Monetary Fund. " Purchasing Power Parity: Weights Matter. "

World Bank. " International Comparison Program (ICP): History ."

World Bank. " International Comparison Program (ICP): Uses ."

World Bank. " International Comparison Program (ICP): Overview ."

World Bank. " Who uses PPPs – Examples of Uses by International Organizations ."

World Population Review. " Purchasing Power Parity by Country 2023 ."

St. Louis Federal Reserve Bank. " Burgernomics: A Big Mac Guide to Purchasing Power Parity ," Page 1.

St. Louis Federal Reserve Bank. " Burgernomics: A Big Mac Guide to Purchasing Power Parity ," Pages 16-17.

St. Louis Federal Reserve Bank. " Burgernomics: A Big Mac Guide to Purchasing Power Parity ," Page 21.

TheGlobalEconomy.com. " GDP per capita, PPP – Country Rankings ."

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Purchasing Power Parity in Economic History

• First Online: 06 October 2022

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• Lawrence H. Officer 2  

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Purchasing power parity (PPP) is given a sympathetic and expansive treatment from the standpoint of economic history. While only relative PPP is discussed, for lack of data on the absolute version in these early times, PPP is interpreted broadly in “augmented” form to include variables beyond exchange rate and price indexes. A wide range of techniques for testing and applying PPP is outlined and accepted. Periods examined range from the Roman Empire to the 1930s. In sum, PPP provides a perspective that enriches our understanding of the relationship between exchange rates and commodity prices over the vast expanse of human history.

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Officer, L.H. (2022). Purchasing Power Parity in Economic History. In: Essays in Economic History. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-95925-8_3

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Purchasing Power Parity and Brand-Related Pricing Essay

Purchasing power parity (ppp), brand and pricing.

The PPP theory is very practical. It emerged with the abolition of the gold standard when an acute need for a new “right” correlations among the currencies of different states had occurred. In an early version of the theory, it was suggested that the value of the exchange rate between currencies under free trade conditions (i.e., with minimum trade restrictions) is determined by the relationship between their purchasing forces (James, Marsh, & Sarno, 2012). It means that following the primary function of money (i.e., a medium of exchange), the desire of economic agents to exchange one currency for another could be directly related to how many goods and services one can buy with it in the relevant country (James et al., 2012).

A more recent version of ​​the PPP theory suggests that the exchange rate value depends directly on the domestic purchasing power of the currency. In the given context, if the level of prices due to inflation in the United States changes, then the dollar exchange rate should change following the final result of those changes in prices (James et al., 2012). It means that if the price level in the country will grow by 50 percent, while the price level in other countries will remain the same, then the value of the dollar, expressed in the currency of other states, should decrease by 50 percent. Overall, as a result of inflation caused by excess money emission, the purchasing power of the national currency for all goods and services, including those involved in international trade, will decrease.

The implementation of the PPP indicator makes sense in comparison with other countries. It represents their economical size, potentials, and power (World Bank, 2015). The decrease in the dollar’s PPP may thus imply the deterioration of the United States’ position in the global economy.

Brand-related pricing differs from other traditional approaches to establishing prices for products. When implementing the given strategy, it is necessary to take into account intangible assets: potential impacts of the trademark on the consumer, the realization of the brand value, i.e., an increase in its profitability. Besides, it is necessary to determine the brand’s position, investment policy, and distribution channels, i.e., take into account all the components of the brand asset management process.

By their nature, intangible elements represent a qualitative characteristic of the brand. They are difficult to quantify, as they represent potential revenues generated due to the introduction of the brand into the commodity circulation (Bakker, 2015). Since the brand is in a certain relation to the price strategy, it is possible to realize the brand value as an asset in the form of capital, i.e., increase profits based on the difference between the exchange price of goods and the buyers’ price (Bakker, 2015). It is possible to say that both brand equity and brand image represent the potential for the formation of a higher (premium) price compared to the nearest competing brand. Studies on brand management also show that the value of the brand can be mediated through such variables as consumer loyalty (Guzmán & Iglesias, 2012).

Overall, when determining pricing and strategic priorities, the company should determine what additional benefits it will receive at the expense of the brand values (its attributes, quality, image, convenience, loyalty, etc.). With proper use of these benefits, the value of the brand as an asset will bring additional profit to the organization through the increase in product prices or profit margins, as well as the reduction of costs associated with the brand.

Bakker, D. (2015). Vertical brand portfolio management: Strategies for integrated brand management between manufacturers and retailers . Wiesbaden, Germany: Springer.

Guzmán, F., & Iglesias, O. (2012). The challenges facing brand managers today . Bradford, UK: Emerald Insight.

James, J., Marsh, I. W., & Sarno, L. (2012). Handbook of exchange rates . Hoboken, NJ: John Wiley & Sons.

World Bank. (2015). Purchasing power parities and the real size of world economies: A comprehensive report of the 2011 international comparison program . Washington, DC: World Bank Group.

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IvyPanda . "Purchasing Power Parity and Brand-Related Pricing." January 21, 2024. https://ivypanda.com/essays/purchasing-power-parity-and-brand-related-pricing/.

• Purchasing Power Parity Theory
• Parity Conditions and Country's Evolution
• The Theory of Purchasing Power Parity
• The Practical Value of Purchasing Power Parity Theory
• Purchasing Power Parity Theory in Statistical Test
• Purchasing Power Parity Definition and Challenges
• Big Mac Index in "Burgernomics" by Pakko & Pollard
• Foreign Exchange Markets Assess
• A PPP Framework for Public Housing in China
• Room Rate Parity Across Different Distribution Channels
• Singapore's Economic Freedom and People's Welfare
• The United Arabs Emirates' Economic Risk Analysis
• Monetary Union Impact on Gulf Cooperation Council
• South African as a Developing Economy
• Australia’s Wool in a Competitive Fiber Market

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Purchasing Power Parity, Research Paper Example

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Purchasing Power Parity is a theory that implies to an important financial concept that is applicable in the process of estimation of potential adjustments of the exchange rates amongst states so as to harmonize the exchange to the purchasing power of their currency. The Big Mac Index is applied in atypical manner for the determination of Purchasing power parity of two states. It serves the role of simplifying the exchange rate mechanism which appears to be complicated (Taylor, 1995).

So many changes are encountered as an individual moves from one corner of the planet to the other but appropriate measures of currency conversion have been put in place by the economists. Consequently, the value of similar products available in diverse nations is expected to be similar after the exchange rate of the two nations has been adjusted (Taylor & Peel, 2000).

Purchasing Power Parity is a relationship that has undergone an extensive analysis in global monetary literature. The simplest way to calculate purchasing power parity between two countries is to compare the price of a “standard” good that is in fact identical across countries. The relative version of PPP is calculated as:

S = (P1/P2)

Where: ‘S’ stands for currency 1 exchange rate relative to currency 2

‘P1’ stands for cost of a product “x” in currency 1

‘P2’ stands for cost of a product “x” in currency 2 (Taylor & Peel, 2000).

The theory of Purchasing power parity is an important tool that facilitates for a comprehensive understanding of the exchange rate differentials. It is however imperative to note that exchange rates do not always converge in the long run as predicted by PPP. Purchasing power parity has been an interesting issue to the economists and has been applied as a very beneficial building block of macroeconomics models in numerous open economies. However, it has been associated with significant complexities in its empirical establishment.

Importance Of PPP In Managing Risks

One of the primary uses of PPP is in reducing the misleading effects of shifts in a national currency. This comes into play when calculating the nation’s Gross Domestic Product (GDP). For example, if a good in a particular country falls in value to 80% of its original value on the dollar, the GDP will also drop 80% as expressed in US dollars. This phenomenon does not reflect the standard of living in that country, a common use of GDP (Cuddington, & Liang, 2000).

According to purchasing power parity, the price for any one good should be equal across markets. This therefore means that the price for any combination or basket of goods should be equalized. This theory however does not always work in practice. In fact, anything which limits the free trade of goods will limit the opportunities people have in taking advantage of the profits resulting from the disparity in the prices of the particular goods in any two given countries (Fleissig & Strauss, 2000). A few of the larger limits are:

Import and Export Restrictions

Restrictions such as quotas, tariffs and laws make it difficult to buy goods in one market and sell them in another.

Travel costs

If it is very expensive to transport goods from one market to another there will be a difference in prices in the two markets.

Perishable goods

It may be impossible to transfer perishable goods from one market to another.

This is a significant limit considering that it might be impossible to buy a piece of property in one state and move it into another. This results in real-estate prices varying wildly. Since the price of land may not be the same everywhere, it will impact on prices, as retailers in one state may have higher expenses than retailers in the other state.

Exchange risk refers to a simple concept of gain or losses that are incurred due to the changes in exchange rates. The effects of a risk are minimized if it can be anticipated which is evident in some currencies whose contracts of forward exchange indicate the direction of the currencies in the market. The contracts are the basis of the ability of locking anticipated changes and the anticipated changes in the exchange rates gives the idea of managing exchange risk (Cuddington & Liang, 2000).

The rates of exchange, rates of inflation and the interest rates have a common link through some classical relationships which in turn have considerable impact on risks allied tied to corporate foreign exchange, the relationships include the theory of PPP, international fisher effect and the theory of unbiased forward rate (Fleissig & Strauss, 2000).

Research Method

This section spells out the procedures and the methods that the researcher employed in achieving the objectives of the project so highlighted in the abstract of this paper. The research starts with the clear understanding of the research objectives that are intended to be achieved in this paper. Success of the project is a factor of the provision of satisfying information in line with the in the determination of the contribution of purchasing power parity in managing risks (Fleissig & Strauss, 2000).

Research Procedure

This research has adopted the option of secondary specifically dealing with the collection and use of existing data. The main advantage of secondary research is that it is not as time consuming as primary research (Cuddington & Liang, 2000).  However, information obtained through secondary sources may not be accurate as to meet the objectives of a particular research study. Regarding the current research study, the main sources of secondary data are;

• Previous researches papers on the subjects
• Relevant journals and books especially those touching on purchasing power parity and Global Financing and Exchange Rate Mechanisms
• Relevant internet sources
• Other related sociology materials as the researcher finds appropriate to use.

Validity and Reliability of Results

A debate about the findings of the preceding literatures inevitably includes a discussion of ‘research’, normally referring to the way in which the collection and use of existing data is achieved. This research being a phenomenological one will have all data collected being related to theoretical characteristics discussed in the literature review. The process will therefore be expected to be accurate in collecting the data and as such, the validity of the research would be quite high notwithstanding the fact that there are many different aspects of validity which influence the validity of a research in general.

Limitations Of The Research

Limitations are usually present in every research and these limitations actually tarnish the results of the research. Certain limitations are also associated with this research. Certain chunks or sources of secondary research are treated as a limitation of the research. This is because of the fact that these sources are not valid or they are not updated therefore the data that is attained from these sources might affect the entire results of the research. Therefore, the researcher should take utmost care about all these constraints and try to minimize it

Cuddington, J., & Liang, H., (2000). “Purchasing power parity over two centuries?” Journalof International Money &Finance 19 (5), 753e757.

Fleissig, R., & Strauss, J., (2000). “Panel unit root tests of purchasing power parity for price indices”. Journal of International Money & Finance 19 (4), 489e506.

Taylor, P., (1995). “The Economics of Exchange Rates”. Journal of Economic Literature, 33, 13-47.

Taylor, P., & Peel, A., (2000). “Nonlinear adjustment, long-ran equilibrium & exchange rate      fundamentals”. Journal of International Money & Finance 19 (1), 33e53.

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The PPP theory has been deemed to have a reservation for the exchange rates depreciation or appreciation as well as the rate of inflation change. It is in this reservation that PPP is found to be in favor of long- term exchange rates model as opposed to the short term due to the volatility of the inflation rate that influences the exchange rate both significantly and insignificantly. A perfect example is the PPP relationship between the American dollar and Canadian dollar between the period spanning 1950 to 1986. This study came to a major conclusion that the deviations that existed from the PPP relationship in comparing the purchasing power between these two currencies at their given exchange rate at the time, were consistently significant in elaborating on the changes in the domestic prices in a fixed exchange rate or a flexible one PPP generally provides a guiding tool for the economists and financial analysts to predict the changing levels of exchange rates. This is despite the fact that PPP holds under the condition that the exchange rate is consistent for a long period of time. This leaves the specialists to question whether or not the PPP theory suggests a true fact, and whether it leaves the exchange rate being under- valued or over- valued. Time series data has proposed a series of tests that tend to provide whether the PPP relationship holds in the short- run, but nothing conclusive has yet been established, what is left is speculation on its effect and its reservations in the long- run effects on exchange rates. What might affect the PPP in the short run is the nominal shocks on currencies of given countries might undergo thus leaving the PPP theory hanging in the balance as these shocks may have dire effect on the exchange rate, therefore conclusively stating that PPP may not hold in the short run due to such conditions.

Bibliography

Arize, A., Malindretos, J., & Ghosh, D. (2015). Purchasing power parity-symmetry and proportionality: Evidence from 116 countries. International Review of Economics and Finance, 69-85. Johnson, D. (1990). Co- integration, error correction, and purchasing power parity between Canada and the United States . Canadian Journal of Economics, 839-855. Marston, R. (1997). Tests of three parity conditions: Distinguishing risk premia and systematic forecast errors . Jounal of International Money and Finance, 285- 303. Taylor, A., & Taylor, M. (2004). The Purchasing Power Parity Debate. Journal of Economic Perspectives, 135-158.

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