Purchasing power parity theory: development, applications, and limitations

Purchasing Power Parity (PPP) theory states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. It is based on the concept that identical goods in an efficient market must have the same price when measured in a common currency. Proponents of the theory believe that comparison of the market exchange rates of currencies of various countries and comparison with their PPP exchange rates are a reflection of their over or under-valuation. Moreover, GDP per capita based on PPP provides a more accurate method of comparing the standard of living in different countries than the conventional GDP per capita (nominal) based on the market exchange rate since the prices of a number of goods and services vary widely between countries at the market exchange rates. This paper gives an overview of the concept of purchasing power parity including its effects on the prices and businesses, explores the background, usefulness and limitations of the theory.

Background of the Development of the Theory

The concept of PPP is not new; several pre-Classical and Classical economists, especially Ricardo, have touched upon the concept in their writings, although they did not name the theory as such. However, the Swedish economist Gustav Cassel is widely credited with credited for its development in the present form during the 1920s, as he was an enthusiastic proponent of the concept of price parity. Maynard Keynes also used the concept in a 1925 pamphlet the Economic Consequences of Mr. Churchill when he severely criticized Churchill (who was the then Britain's Chancellor of the Exchequer) for returning the UK to the gold standard at the pre-war parity. Keynes, by comparing the existing prices of certain common goods in the UK and the U.S., argued in the pamphlet that the move had made UK's currency grossly overvalued relative to its real (PPP) level and that the competitiveness of UK manufacturing would suffer as a result. Needless to add; Keynes' prediction proved prophetic (Neary 2004).

PPP as an Extension of the 'Law of One Price'

The purchasing power parity theory is actually an extension and variation of a basic economic principle called the "law of one price" which states: "In an efficient market all identical goods must have only one price." In other words, the law suggests that different prices of a traded good in different countries will tend to equalize in the absence of trade barriers such as tariffs, and high transportation costs. Other caveats to the law of one price are that it only applies to trade-able goods and competitive markets for goods and services in both countries must exist. Hence, if the price of a tradeable good is cheaper in a country as compared to another, the situation would present a profit making opportunity for the entrepreneurs who would buy the good in the low price market and resell it in the high price market. As a consequence price of the good would eventually converge and equalize (Suranovic, 2006).

When the law of one price is applied in aggregate, we come up with the purchasing power parity theory, which states that the exchange rate in two countries is in equilibrium when the price of a basket of trade-able goods is the same in both countries. If we take a hypothetical example of comparing the price of goods in two countries (say the U.S. And Mexico) and assume that the cost of a basket of goods in the U.S. denominated in dollars (CB$) is 100 and the cost of the basket of same goods in Mexico in pesos (CBp) is 1000; then the PPP exchange rate (pesos per dollars) will equal the ratio of the costs of the two market baskets of goods, and in the above example, if one U.S. $ is equal to ten (10) pesos, the exchange rate would be considered to be in equilibrium. Expressed in the form of an equation:

(PPP)p/$ = CBp / CB$

Where E (PPP)p/$ is the peso v dollar exchange rate)

Extending our above-mentioned hypothetical example further, if the existing spot exchange rate of peso / $ was less than 10, the peso would be considered overvalued and if the existing exchange rate was more than 10, the peso could be deemed as undervalued. According to the PPP theory, the exchange rate tends to move towards its equilibrium value in the long-run. Hence, the difference between the "law of one price" and the theory of PPP is that in the former, the market price of the same good is equalized over time, while in the latter the exchange rate is affected (Ibid.)

Relative PPP

The PPP theory described above is sometimes termed the "absolute PPP" to distinguish it from an alternative version of the theory called "relative PPP." The relative PPP theory suggests that exchange rate changes over time are dependent on inflation rate differentials between countries; the implication being that if, for example, the Mexican inflation rate exceeds the U.S. inflation rate, then the dollar will appreciate by that differential over the same period and vice versa. The logic of this theory is the same as in absolute PPP; it only expands the theory further by suggesting that the exchange rate would change in a systematic way given that a continual change in the price level (inflation) is occurring ("Purchasing Power Parity" n.d. -- University of British Columbia).

Limitations of the PPP Theory

Although the PPP theory has its usefulness as an economic concept, it also has its limitations. The main drawback of the theory is that the PPP condition is rarely satisfied within a country due to the reasons explained below:

Transportation Costs and Trade Barriers: The 'law of one price', from which the PPP theory is derived, assumes that there are no (or negligible) transportation costs and taxes on goods being traded between countries; the same assumptions hold true for the PPP theory. This is obviously not the case in the real world. Substantial transportation costs are often involved besides taxes and other restrictions on trade, despite a declining trend in recent years due to WTO covenants. These costs tend to drive prices for similar goods apart in the exporting and importing countries, with the goods being cheaper in the exporting market and more expensive in the importing market (Suranovic, 2006).

Costs of Non-Tradable Inputs Another condition for the PPP theory to hold true is that the goods involved should be 'tradable goods.' Almost every manufactured item, however, contains some inputs that are non-tradable. Consider the example of McDonald's Big Mac hamburger. Even within one country it may not be possible for the price of the Big Mac to be the same. This is because a McDonald outlet in the city center would have at least one production input (the rent of the restaurant space) to be more expensive than the rental space in the suburbs or in a small town (Ibid.).

Basket of Goods the PPP exchange rate calculations are also controversial because of the difficulties involved in finding comparable 'baskets of goods' to compare purchasing power across countries. People in different countries typically consume different baskets of goods; assign varying priorities to different goods; and even the goods available for purchase may differ across countries. Moreover, what is considered a luxury in one culture could be considered a necessity in another. The PPP exchange rate would consequently vary greatly depending on the choice of goods used for the index and makes it vulnerable to errors due to a deliberate or accidental bias in calculations by the choice of a differing bundle.

Quality of Goods: While comparing the prices of goods in different countries for the purpose of calculating PPP, the quality of goods is not taken into account. For instance, a hat is considered to be just a hat although the value of a shoddily made hat would be considerably lower than that of a well made high quality hat.

Measuring Poverty with PPP International monetary agencies such as the World Bank and the IMF frequently use the purchasing power parity to measure global poverty. The approach has been severely criticized in a Columbia University Study in 2005 titled "How Not to Count the Poor." The study argues that employing "a concept of purchasing power 'equivalence' that is neither well defined nor appropriate for poverty assessment" has led the World Bank to "understate the extent of global income poverty and to infer without adequate justification that global income poverty has steeply declined in the recent period" (Reddy and Pogge, 2005)

Conclusion

The purchasing power parity (PPP) theory is a useful economic concept that helps economists to compare the 'real' purchasing power of people in different countries by equalizing their GDP on the basis of an adjusted PPP exchange rate rather than the market exchange rate. It can also sometimes help us to evaluate whether the currency of a particular is under or over valued. The theory should, however, be used with caution as it has its limitations mainly due to the fact that the conditions required for PPP such as the absence of trade barriers and transportation costs and tradability of all goods do not exist in the real world.