• A concept to understand when evaluating the economic health of nations and the relative dynamics between international markets is the idea of purchasing power parity (PPP). • Distilled to its basic form, purchasing power parity is a ratio that displays the relative price level differences across two countries for similar products or group of products. PPP is used as a first step in making inter-country comparisons based in real terms of gross domestic product (GDP) and its component expenditures. • PPP allows countries to be viewed through a common reference point. Taken as a long-term theory, one should expect a convergence of all prices for common goods around the world in order for equilibrium to take affect and mitigate cost arbitrage opportunities.
An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power. The basic tenet of this principle is that the exchange rates between various currencies reflect the purchasing power of these currencies. This tenet is based on the law of one price.
1. Movement of goods: The law of one price assumes that there is no restriction on the movement of goods implying that there is no curb by any country in the form of ban as well as quota on exports and imports and international trade can take place between various countries.
2. No tariffs: It also assumes there is no tariff imposed by the countries, also there are no transaction costs associated with buying and selling of goods in various countries. 3. No transportation cost: It also assumes the absence of transportation costs which are associated with the export and import of goods in order to be law of one price to be valid. 4. No transaction costs: This law assumes that there are no transaction costs involved in the buying and selling of goods.
Absolute PPP : Using the intuition built by the law of one price for a discrete product, one can apply the principle across an aggregate of products and prices. Or putting in another way, one can imagine a common basket of goods that can be traded and prices compared across two countries- this is also known as the consumer price index (CPI).
PA = S(A/B) X PB
The Relative Form of PPP : In order to control a constant price differential between the two country’s indices, one can focus on measuring the relative purchasing power parity. Using a relative PPP allows for a different basket of goods and varying weights to be applied towards the goods within the CPI.
S (A/B) = PA-PB/ 1+PB
The expectation form of PPP: According to this form of PPP, the expected percentage change in the spot rate is equal to the difference in the expected inflation rates in the two countries. Let the expected percentage change in the spot rate be denoted by S*(A/B), The expected inflation rate in country A by PB .
PA = + S(A/B)
S(A/B) = PA- PB
This equation is called the expectation form or this efficient market form of PPP. As can be observed, it is similar to equation8, with all the variables being expressed in expected terms. So, if the Indian inflation rate is expected to be 8% over the next year and the US inflation rate is expected to be 2%, the Rs/$ exchange rate can be expected to change by 6%.
The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.
Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services.
Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP. The purchasing power parity theory states that the exchange rate between one currency and another currency is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
PPP estimates can also vary based on the statistical capacity of participating countries.
Some aspects of PPP comparison are theoretically impossible or unclear. PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages.
The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for homecountry use. Also, currencies are traded for purposes other than trade in goods and services. The PPP method is used as an alternative to correct for possible statistical bias. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong.
The goods that the currency has the "power" to purchase are a basket of goods of different types: •Local, non-tradable goods and services (like electric power) that are produced and sold domestically. •Tradable goods such as non-perishable commodities that can be sold on the international market (like diamonds).
The law of one price, the underlying mechanism behind PPP, is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price.
Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of differing demand conditions between countries.
There have been numerous studies to prove out the various theories surrounding PPP and its efficiency along particular time horizons. There has been a long standing belief that PPP is an effective tool to understand real exchange rates and their natural equilibrium states in the long-run. There is a consensus that the speed of convergence is relatively slow compared to the rampant shifts to exchange rates in the short-term (some experts believe the half-life of shocks exhibited by short-term exchange rates fluctuations is anywhere from two to three years). Regardless, it is important to understand that purchasing power parity is a powerful tool that provides us a common lens by which to view the economic health and condition of different countries. Just as with any tool or device, we must be cognizant of the limitations and weakness of PPP and understand how we can control those limitations within a particular data set.
doc_346772638.pptx
An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power. The basic tenet of this principle is that the exchange rates between various currencies reflect the purchasing power of these currencies. This tenet is based on the law of one price.
1. Movement of goods: The law of one price assumes that there is no restriction on the movement of goods implying that there is no curb by any country in the form of ban as well as quota on exports and imports and international trade can take place between various countries.
2. No tariffs: It also assumes there is no tariff imposed by the countries, also there are no transaction costs associated with buying and selling of goods in various countries. 3. No transportation cost: It also assumes the absence of transportation costs which are associated with the export and import of goods in order to be law of one price to be valid. 4. No transaction costs: This law assumes that there are no transaction costs involved in the buying and selling of goods.
Absolute PPP : Using the intuition built by the law of one price for a discrete product, one can apply the principle across an aggregate of products and prices. Or putting in another way, one can imagine a common basket of goods that can be traded and prices compared across two countries- this is also known as the consumer price index (CPI).
PA = S(A/B) X PB
The Relative Form of PPP : In order to control a constant price differential between the two country’s indices, one can focus on measuring the relative purchasing power parity. Using a relative PPP allows for a different basket of goods and varying weights to be applied towards the goods within the CPI.
S (A/B) = PA-PB/ 1+PB
The expectation form of PPP: According to this form of PPP, the expected percentage change in the spot rate is equal to the difference in the expected inflation rates in the two countries. Let the expected percentage change in the spot rate be denoted by S*(A/B), The expected inflation rate in country A by PB .
PA = + S(A/B)
S(A/B) = PA- PB
This equation is called the expectation form or this efficient market form of PPP. As can be observed, it is similar to equation8, with all the variables being expressed in expected terms. So, if the Indian inflation rate is expected to be 8% over the next year and the US inflation rate is expected to be 2%, the Rs/$ exchange rate can be expected to change by 6%.
The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.
Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services.
Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP. The purchasing power parity theory states that the exchange rate between one currency and another currency is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
PPP estimates can also vary based on the statistical capacity of participating countries.
Some aspects of PPP comparison are theoretically impossible or unclear. PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages.
The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for homecountry use. Also, currencies are traded for purposes other than trade in goods and services. The PPP method is used as an alternative to correct for possible statistical bias. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong.
The goods that the currency has the "power" to purchase are a basket of goods of different types: •Local, non-tradable goods and services (like electric power) that are produced and sold domestically. •Tradable goods such as non-perishable commodities that can be sold on the international market (like diamonds).
The law of one price, the underlying mechanism behind PPP, is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price.
Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of differing demand conditions between countries.
There have been numerous studies to prove out the various theories surrounding PPP and its efficiency along particular time horizons. There has been a long standing belief that PPP is an effective tool to understand real exchange rates and their natural equilibrium states in the long-run. There is a consensus that the speed of convergence is relatively slow compared to the rampant shifts to exchange rates in the short-term (some experts believe the half-life of shocks exhibited by short-term exchange rates fluctuations is anywhere from two to three years). Regardless, it is important to understand that purchasing power parity is a powerful tool that provides us a common lens by which to view the economic health and condition of different countries. Just as with any tool or device, we must be cognizant of the limitations and weakness of PPP and understand how we can control those limitations within a particular data set.
doc_346772638.pptx