Business, Legal & Accounting Glossary
The purchasing power parity is the concept that two countries’ exchange rates for currency equalize the difference in purchasing power between the two currencies.
The theory that, in the long run, identical products and services in different countries should cost the same in different countries. This is based on the belief that exchange rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another. For example, consider a laptop computer that costs 1,500 Euros in Germany and an exchange rate of 2 Euros to 1 U.S. Dollar. If the same laptop cost 1,000 dollars in the United States, U.S. consumers would buy the laptop in Germany. If done on a large scale, the influx of U.S. dollars would drive up the price of the Euro, until it equalized at 1.5 Euros to 1 U.S. Dollar – the same ratio of the price of the laptop in Germany to the price of the laptop in the U.S. The theory only applies to tradable goods, not to immobile goods or local services. The theory also discounts several real-world factors, such as transportation costs, tariffs, and transaction costs. It also assumes there are competitive markets for the goods and services in both countries.
Purchasing power parity calculates exchange rates in terms of how much goods a currency can buy.
Purchasing power parity (PPP) is a way to compare the value of currencies after factoring out swings in exchange rates that are caused by macroeconomic forces that haven’t yet impacted the purchasing power of citizens. The Economist came up with the “Big Mac Index” as a way to explain PPP.
The goal is to figure out the exchange rate that makes it possible to buy a Big Mac in another country for the same price as it costs in the U.S. Let’s use France as an example and $3.50 as the price of a Big Mac. I want to be able to convert that $3.50 into euros and buy a Big Mac with those euros.
Purchasing power parity takes a look at the exchange rate needed so that my $3.50 will buy a Big Mac in the U.S. or a Big Mac in France. It then compares this to the exchange rate of the currencies on the market and uses the difference as a way to judge whether the euro is undervalued or overvalued.
Here’s how purchasing power parity works:
Imagine two countries, Alphastan and Betastan, produce only widgets. A widget costs 1 alpha in Alphastan and 3 betas in Betastan. The current exchange rate is 1 alpha = 6 betas. Under purchasing power parity, the alpha is overvalued vis-à-vis the beta, because each alpha buys goods worth only 3 betas. Alphastanians conscious of purchasing power parity would rush to Betastan, get six betas for an alpha, buy two widgets (6 beta/3 beta per widget) per alpha, and rush home. Purchasing power parity would thus anticipate that the people in Alphastan would bid up the beta until an alpha bought only 3 beta.
Since purchasing power parity computations require that the goods be the same in every country, the Economist magazine uses a McDonald’s hamburger for its world index of purchasing power parity. While more sophisticated analyses use a bundle of goods to compute purchasing power parity, determining purchasing power parity for complex economies remains difficult.
PPP
Gross domestic product
Exchange Rate
Big Mac Index
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This glossary post was last updated: 29th November, 2021 | 0 Views.