INTRODUCTION
An important 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). The basic theory asserts that the prices of common goods between two countries should be equal once prices have been converted to a common currency. 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. GDP is commonly used as a economic indicator for size, growth, and health of a nation. PPP allows countries to be viewed through a common reference point.1 Taken as a longterm 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. This note will provide the reader a deeper understanding of how the theory of purchasing power parity works, the practical application of PPP, flaws surrounding the application, and the relationship between PPP and real exchange rates.
Definition of purchase power parity theory:
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.
Law of One Price
The law of one price says that identical goods should sell for the same price in two separate markets.
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. As an example, consider a basic ingredient to the Big MacTM like a beef patty. Assume the price for a beef patty in the United States is represented as pbp$ and the price of the same beef patty in the France is represented as pbp€, the law of one price can be expressed mathematically as follows:
pbp€ = E x pbp$
here, E is the exchange rate between the euro/dollar. Assume the cost of a pre-formed beef patty in the U.S. is $1.00 per patty. If the euro/dollar exchange rate is 0.845316 (the spot rate as of 12/07/2005), then the price for the same beef patty in France should be €0.85. An arbitrage opportunity could arise if the pre-formed patty sold for anything less than €0.85 in France. A shrewd trader could then purchase pre-formed beef patties in France and resell them in the U.S. for an tidy profit until supply and demand forces took hold and drove down the prices in the U.S. market while driving up the prices in the French market. This process would repeat itself until price convergence is achieved. Thus, the law of one price holds true within this iterative pricing cycle for a discrete product like the beef patty.
1. 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 put 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 adaptation of the law of one price to PPP brings a particular nuance or wrinkle. In the beef patty arbitrage example cited above, the trader would take advantage of the price differences between two markets and the exchange rate was assumed constant. Here, there is an attempt to hold the price levels constant and it is the exchange rate that fluctuates. This becomes basis of the idea that PPP as a determinant of the exchange rates.
2. The Relative form of PPP
One sees from the discussion above, in order to control for 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. This is because relative PPP states that fluctuations in the pricing levels will be related to the fluctuations in the exchange rates. Changes in relative exchange rates are attributed to varying inflation rates across countries. Thus, relative PPP can be expressed as follows:
S (A/B) = PA-PB/ 1+PB
3. 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%.
Reasons for PPP not holding good:
Earlier sections mention the assumption application to the law of one price and to the various forms of PPP. If any of these assumption does not hold well, the PPP would also not hold. Besides, even- if PPP were actually holding-good, the result of an empirical study could get affected by the statistical methodsemployed. These factors give rise to the following reasons for PPP not holding good: • • • Constraints on movement of commodities Price index construction Effect of the statistical method employed.
The facts that PPP does not always hold goods, gives rise to the concept of real exchange rate. The spot rate, adjusted for the change in price levels in the two countries during a specific period, gives the real exchange rate. Any change in the real exchange rate is called the real appreciation or depreciation of the currency. One of the ways to calculate the real exchange rate is: Sr (A/B) = S (A/B) X IB/IA Where, S (A/B) is the spot rate at a point of time IB and IA are the price indexes (like consumer price index CPI or wholesale price index WPI) in the respective countries having the same base year, and Sr is the real exchange rate. For example, if the spot rate is Rs.42.50/$, and the price index in India and the US is at 110 and 103 respectively, the real exchange rate will be
Sr = 48.5 (103/110) = Rs.45.41/$ If the real exchange rate in the base period (i.e. at the beginning of the period over which the relevant inflation rates are applicable) was Rs.47.68/$, the rupee can be said to have appreciation in real terms.
Measurement
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. Furthermore, the basket of goods representative of one economy will vary from that of another; Americans eat more bread, Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs can provide a more stabile multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was $0.91 US, and in Norway the price was $6.27 US. The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite
all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
Relationship between PPP and law of one price
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.
Big Mac Index
An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known food whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government regulations, product differentiation, and prices of nonfood inputs.Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few
substitutes for the Big Mac allows McDonald's to have market power. Countries like Argentina that have abundant beef resources see a structural underpricing in the Big Mac.
Starbucks tall latte index
The Starbucks tall latte index is a variant of the Big Mac Index; it can give information regarding exchange rates similar to the Big Mac Index. The tall latte index was compiled in 2004, during which time both a Big Mac and tall latte cost $2.80. The measures told the same story in most cases with the notable exception of Asia. According to the Big Mac index, the yen was 12% undervalued against the dollar, whereas it was 13% overvalued according to the tall latte index. Furthermore, the Chinese yuan was 56% undervalued based on the Big Mac index but neither significantly undervalued nor overvalued according to the Starbucks index. The following table, based on data from The Economist's 2004 calculations, shows the under (-) and over (+) valuation of the local currency against the dollar in %, according to the Starbucks tall latte index and the Big Mac index. Country Australia United Kingdom Canada China Eurozone Hong Kong Japan Malaysia Mexico New Zealand Singapore South Korea Switzerland Taiwan Thailand Turkey Starbucks tall latte McDonald's Big Mac index Index -4 -17 +17 -16 -1 +33 +15 +13 -25 -15 -12 +2 +6 +62 -5 -31 +6 +23 -16 -56 +24 -45 -12 -53 -21 -4 -31 0 +82 -21 -46 +5
OECD comparative price levels
Each month, the Organisation for Economic Co-operation and Development measures the difference in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed, as of September 2011, in each of the countries listed to buy the same representative basket of consumer goods and services that would cost 100 USD in the United States. According to the table, an American living in Switzerland on an income denominated in US dollars would find that country (in September 2011) to be one of the most expensive in world, having to spend almost double the US dollars to maintain a standard of living comparable to the USA in terms of Price level (USA = consumption. Country 100) Australia 162 Austria 122 Belgium 127 Measurement issues Canada 130 Chile 75 In addition to methodological Czech 83 issues presented by the selection of a Republic basket of goods, PPP estimates can also Denmark 162 vary based on the statistical capacity of Estonia 94 participating countries. The International Finland 138 Comparison Program, which PPP France 126 estimates are based on, require the Germany 117 disaggregation of national accounts into Greece 109 production, expenditure or (in some cases) income, and not all participating Hungary 75 countries routinely disaggregate their Iceland 125 data into such categories. Ireland 137 Israel 122 Some aspects of PPP comparison Italy 109 are theoretically impossible or unclear. Japan 156 For example, there is no basis for South Korea 84 comparison between the Ethiopian Luxembourg 134 laborer who lives on teff with the Thai Mexico 67 laborer who lives on rice, because teff is impossible to find in Thailand and vice Netherlands 121 versa, so the price of rice in Ethiopia or New Zealand 132 teff in Thailand cannot be determined. Norway 170 As a general rule, the more similar the Poland 64 price structure between countries, the Portugal 106 more valid the PPP comparison. Slovakia 82 Slovenia 98 PPP levels will also vary based on Spain 110 the formula used to calculate price Sweden 135 Switzerland 193 Turkey 58 United 124 Kingdom
matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages. Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which is not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.
2005 ICP
The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (-42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of $153 1985 International dollars, but Pritchett has persuasively argued that $250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to $229. Angus Deaton and Alan Heston have suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%.
Need for PPP adjustments to GDP
Gross domestic product (by purchasing power parity) in 2006 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, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem. 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. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison.
Difficulties
There are a number of reasons that different measures do not perfectly reflect standards of living.
Range and quality of goods
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 (like diamonds). The more that a product falls into category 1, the more that its price will be from the currency exchange rate, moving towards the PPP exchange rate. Conversely, category 2 products tend to trade close to the currency exchange rate. (See also Penn effect). 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 Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and nontradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes farther in lowincome countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate
than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries. The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the Balassa-Samuelson theory. This view states that price levels for non tradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Non tradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for non tradables, non tradables are cheaper in poor countries. Wages are high in rich countries, so non tradables are relatively more expensive. PPP calculations tend to overemphasize the primary contribution, and underemphasize the industrial and service contributions to the economy of a nation. sectoral sectoral
Trade barriers and non tradables
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. As transport costs increase, the larger the range of exchange rate fluctuations. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country."[3] They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago, which is certainly not the case. Non tradables are primarily services and the output of the construction industry. Non tradables also lead to deviations in PPP because the prices of non tradables are not linked internationally. The prices are determined by domestic supply and demand, and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of non tradables rise, the purchasing power of any given currency will fall in that country.
Departures from free competition
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. According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Overtime, shifts in market structure and demand will occur, which may invalidate relative PPP.
Differences in consumption patterns and price level measurement
Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.[3]
• PPP and global poverty line
The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. The primary problem associated with this calculation lies in the fact that price indexes are weighted averages of prices and both weights and prices could be incorrect. Individuals living at the poverty line may face prices that are different from the average national prices, but the ICP bases calculations on the average national prices. Furthermore, the expenditure patterns at the poverty line are substantially different from national expenditure patterns, and these expenditure patterns in the National Accounts provide the weights used for the consumption PPPs described by the ICP. A recent study published in the American Economic Journal sought to address this issue by using poverty-weighted purchasing power parities, PPPPs
or P4s. Household surveys are the distinguishing difference between P4s and P3s. The study found that the substitution of poverty weights for national accounts does not make a large difference to global poverty counts. It did find, however, that the method of calculating the global poverty line does make a large differences. When the global poverty line was calculated using the weighted average of fifty national poverty lines, the global poverty count was significantly lower than when the poverty lines from the fifteen poorest countries were used, which is the method used by the World Bank to calculate the global poverty line. Because the numbers of people in poverty are used as weights, this difference in outcomes based on the calculation method is explained by countries, such as India, with a large number of people living in poverty that are included in the fifty but not in the fifteen poorest. India has a large number of poor people and, by international standards, a low national poverty line. The global poverty line is much lower when India is included than when it is excluded The study explains dollars were not used to calculate poverty lines: the structure of advanced economies is different from the structure of economies where the global poor live. For this reason, rupees were more appropriate. The study makes recommendations to others who wish to make international comparisons of living standards for how to measure different indexes for the 2005 calendar year and also how to update these indexes when the results of the 2011 ICP become available. Among these recommendations include methods of converting rupees to dollars (which may be done because many people would want to read this information in terms of dollars).
Conclusion
There have been numerous studies to prove out the various theories surrounding PPP and its efficacy 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). However, there has been much debate on the causes of the volatile nature of the short-run exchange rate. So, the conundrum is: how do we reconcile the erratic, and enormous volatility of short term exchange rates with the extremely slow rate of the corrective force of PPP? We have already touched on Balassa-Samuelson’s theory attributing deviations from PPP to the attributes of non-tradable goods, incomes, and productivity difference across nations. There is a more recent study by Engel (1999) that argues against this view by entirely attributing the deviations to the other errors to the law of one price and none to relative prices of nontradable goods. 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_529617218.doc
An important 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). The basic theory asserts that the prices of common goods between two countries should be equal once prices have been converted to a common currency. 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. GDP is commonly used as a economic indicator for size, growth, and health of a nation. PPP allows countries to be viewed through a common reference point.1 Taken as a longterm 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. This note will provide the reader a deeper understanding of how the theory of purchasing power parity works, the practical application of PPP, flaws surrounding the application, and the relationship between PPP and real exchange rates.
Definition of purchase power parity theory:
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.
Law of One Price
The law of one price says that identical goods should sell for the same price in two separate markets.
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. As an example, consider a basic ingredient to the Big MacTM like a beef patty. Assume the price for a beef patty in the United States is represented as pbp$ and the price of the same beef patty in the France is represented as pbp€, the law of one price can be expressed mathematically as follows:
pbp€ = E x pbp$
here, E is the exchange rate between the euro/dollar. Assume the cost of a pre-formed beef patty in the U.S. is $1.00 per patty. If the euro/dollar exchange rate is 0.845316 (the spot rate as of 12/07/2005), then the price for the same beef patty in France should be €0.85. An arbitrage opportunity could arise if the pre-formed patty sold for anything less than €0.85 in France. A shrewd trader could then purchase pre-formed beef patties in France and resell them in the U.S. for an tidy profit until supply and demand forces took hold and drove down the prices in the U.S. market while driving up the prices in the French market. This process would repeat itself until price convergence is achieved. Thus, the law of one price holds true within this iterative pricing cycle for a discrete product like the beef patty.
1. 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 put 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 adaptation of the law of one price to PPP brings a particular nuance or wrinkle. In the beef patty arbitrage example cited above, the trader would take advantage of the price differences between two markets and the exchange rate was assumed constant. Here, there is an attempt to hold the price levels constant and it is the exchange rate that fluctuates. This becomes basis of the idea that PPP as a determinant of the exchange rates.
2. The Relative form of PPP
One sees from the discussion above, in order to control for 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. This is because relative PPP states that fluctuations in the pricing levels will be related to the fluctuations in the exchange rates. Changes in relative exchange rates are attributed to varying inflation rates across countries. Thus, relative PPP can be expressed as follows:
S (A/B) = PA-PB/ 1+PB
3. 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%.
Reasons for PPP not holding good:
Earlier sections mention the assumption application to the law of one price and to the various forms of PPP. If any of these assumption does not hold well, the PPP would also not hold. Besides, even- if PPP were actually holding-good, the result of an empirical study could get affected by the statistical methodsemployed. These factors give rise to the following reasons for PPP not holding good: • • • Constraints on movement of commodities Price index construction Effect of the statistical method employed.
The facts that PPP does not always hold goods, gives rise to the concept of real exchange rate. The spot rate, adjusted for the change in price levels in the two countries during a specific period, gives the real exchange rate. Any change in the real exchange rate is called the real appreciation or depreciation of the currency. One of the ways to calculate the real exchange rate is: Sr (A/B) = S (A/B) X IB/IA Where, S (A/B) is the spot rate at a point of time IB and IA are the price indexes (like consumer price index CPI or wholesale price index WPI) in the respective countries having the same base year, and Sr is the real exchange rate. For example, if the spot rate is Rs.42.50/$, and the price index in India and the US is at 110 and 103 respectively, the real exchange rate will be
Sr = 48.5 (103/110) = Rs.45.41/$ If the real exchange rate in the base period (i.e. at the beginning of the period over which the relevant inflation rates are applicable) was Rs.47.68/$, the rupee can be said to have appreciation in real terms.
Measurement
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. Furthermore, the basket of goods representative of one economy will vary from that of another; Americans eat more bread, Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs can provide a more stabile multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was $0.91 US, and in Norway the price was $6.27 US. The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite
all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
Relationship between PPP and law of one price
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.
Big Mac Index
An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known food whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government regulations, product differentiation, and prices of nonfood inputs.Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few
substitutes for the Big Mac allows McDonald's to have market power. Countries like Argentina that have abundant beef resources see a structural underpricing in the Big Mac.
Starbucks tall latte index
The Starbucks tall latte index is a variant of the Big Mac Index; it can give information regarding exchange rates similar to the Big Mac Index. The tall latte index was compiled in 2004, during which time both a Big Mac and tall latte cost $2.80. The measures told the same story in most cases with the notable exception of Asia. According to the Big Mac index, the yen was 12% undervalued against the dollar, whereas it was 13% overvalued according to the tall latte index. Furthermore, the Chinese yuan was 56% undervalued based on the Big Mac index but neither significantly undervalued nor overvalued according to the Starbucks index. The following table, based on data from The Economist's 2004 calculations, shows the under (-) and over (+) valuation of the local currency against the dollar in %, according to the Starbucks tall latte index and the Big Mac index. Country Australia United Kingdom Canada China Eurozone Hong Kong Japan Malaysia Mexico New Zealand Singapore South Korea Switzerland Taiwan Thailand Turkey Starbucks tall latte McDonald's Big Mac index Index -4 -17 +17 -16 -1 +33 +15 +13 -25 -15 -12 +2 +6 +62 -5 -31 +6 +23 -16 -56 +24 -45 -12 -53 -21 -4 -31 0 +82 -21 -46 +5
OECD comparative price levels
Each month, the Organisation for Economic Co-operation and Development measures the difference in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed, as of September 2011, in each of the countries listed to buy the same representative basket of consumer goods and services that would cost 100 USD in the United States. According to the table, an American living in Switzerland on an income denominated in US dollars would find that country (in September 2011) to be one of the most expensive in world, having to spend almost double the US dollars to maintain a standard of living comparable to the USA in terms of Price level (USA = consumption. Country 100) Australia 162 Austria 122 Belgium 127 Measurement issues Canada 130 Chile 75 In addition to methodological Czech 83 issues presented by the selection of a Republic basket of goods, PPP estimates can also Denmark 162 vary based on the statistical capacity of Estonia 94 participating countries. The International Finland 138 Comparison Program, which PPP France 126 estimates are based on, require the Germany 117 disaggregation of national accounts into Greece 109 production, expenditure or (in some cases) income, and not all participating Hungary 75 countries routinely disaggregate their Iceland 125 data into such categories. Ireland 137 Israel 122 Some aspects of PPP comparison Italy 109 are theoretically impossible or unclear. Japan 156 For example, there is no basis for South Korea 84 comparison between the Ethiopian Luxembourg 134 laborer who lives on teff with the Thai Mexico 67 laborer who lives on rice, because teff is impossible to find in Thailand and vice Netherlands 121 versa, so the price of rice in Ethiopia or New Zealand 132 teff in Thailand cannot be determined. Norway 170 As a general rule, the more similar the Poland 64 price structure between countries, the Portugal 106 more valid the PPP comparison. Slovakia 82 Slovenia 98 PPP levels will also vary based on Spain 110 the formula used to calculate price Sweden 135 Switzerland 193 Turkey 58 United 124 Kingdom
matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages. Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which is not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.
2005 ICP
The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (-42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of $153 1985 International dollars, but Pritchett has persuasively argued that $250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to $229. Angus Deaton and Alan Heston have suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%.
Need for PPP adjustments to GDP
Gross domestic product (by purchasing power parity) in 2006 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, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem. 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. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison.
Difficulties
There are a number of reasons that different measures do not perfectly reflect standards of living.
Range and quality of goods
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 (like diamonds). The more that a product falls into category 1, the more that its price will be from the currency exchange rate, moving towards the PPP exchange rate. Conversely, category 2 products tend to trade close to the currency exchange rate. (See also Penn effect). 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 Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and nontradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes farther in lowincome countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate
than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries. The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the Balassa-Samuelson theory. This view states that price levels for non tradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Non tradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for non tradables, non tradables are cheaper in poor countries. Wages are high in rich countries, so non tradables are relatively more expensive. PPP calculations tend to overemphasize the primary contribution, and underemphasize the industrial and service contributions to the economy of a nation. sectoral sectoral
Trade barriers and non tradables
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. As transport costs increase, the larger the range of exchange rate fluctuations. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country."[3] They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago, which is certainly not the case. Non tradables are primarily services and the output of the construction industry. Non tradables also lead to deviations in PPP because the prices of non tradables are not linked internationally. The prices are determined by domestic supply and demand, and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of non tradables rise, the purchasing power of any given currency will fall in that country.
Departures from free competition
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. According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Overtime, shifts in market structure and demand will occur, which may invalidate relative PPP.
Differences in consumption patterns and price level measurement
Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.[3]
• PPP and global poverty line
The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. The primary problem associated with this calculation lies in the fact that price indexes are weighted averages of prices and both weights and prices could be incorrect. Individuals living at the poverty line may face prices that are different from the average national prices, but the ICP bases calculations on the average national prices. Furthermore, the expenditure patterns at the poverty line are substantially different from national expenditure patterns, and these expenditure patterns in the National Accounts provide the weights used for the consumption PPPs described by the ICP. A recent study published in the American Economic Journal sought to address this issue by using poverty-weighted purchasing power parities, PPPPs
or P4s. Household surveys are the distinguishing difference between P4s and P3s. The study found that the substitution of poverty weights for national accounts does not make a large difference to global poverty counts. It did find, however, that the method of calculating the global poverty line does make a large differences. When the global poverty line was calculated using the weighted average of fifty national poverty lines, the global poverty count was significantly lower than when the poverty lines from the fifteen poorest countries were used, which is the method used by the World Bank to calculate the global poverty line. Because the numbers of people in poverty are used as weights, this difference in outcomes based on the calculation method is explained by countries, such as India, with a large number of people living in poverty that are included in the fifty but not in the fifteen poorest. India has a large number of poor people and, by international standards, a low national poverty line. The global poverty line is much lower when India is included than when it is excluded The study explains dollars were not used to calculate poverty lines: the structure of advanced economies is different from the structure of economies where the global poor live. For this reason, rupees were more appropriate. The study makes recommendations to others who wish to make international comparisons of living standards for how to measure different indexes for the 2005 calendar year and also how to update these indexes when the results of the 2011 ICP become available. Among these recommendations include methods of converting rupees to dollars (which may be done because many people would want to read this information in terms of dollars).
Conclusion
There have been numerous studies to prove out the various theories surrounding PPP and its efficacy 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). However, there has been much debate on the causes of the volatile nature of the short-run exchange rate. So, the conundrum is: how do we reconcile the erratic, and enormous volatility of short term exchange rates with the extremely slow rate of the corrective force of PPP? We have already touched on Balassa-Samuelson’s theory attributing deviations from PPP to the attributes of non-tradable goods, incomes, and productivity difference across nations. There is a more recent study by Engel (1999) that argues against this view by entirely attributing the deviations to the other errors to the law of one price and none to relative prices of nontradable goods. 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.
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