Purchasing Power Parity the Idea

Purchasing Power Parity The idea of purchasing power parity is a long-established economic concept that describes a state of long-term equilibrium of exchange rates that are derived from the relative price levels of two different nations. The first formulation of this model originated in the 16th century in the School of Salamanca but it was not formulized into its current form until the end of World War I. The core of this idea is the dictum of the law of one price.

Put most simply, this law is that idea that if one dismisses any transactional costs, then identical goods will have precisely the same costs in different markets (Lamont & Thaler, 2003). This sounds relatively straightforward, and the idea behind it is. However, when trying to put this into use in the real world of messy international trade and exchange, the complexities multiply so quickly that the usefulness of this concept can seem to be fundamentally compromised.

In the purest (that is, most abstract or theoretical) version of the model of purchasing power parity, the purchasing power of different national currencies is set at an equal value for what economists call a "basket of goods," which is an actual set or collection of goods that is in fact traded between countries (Lamont & Thaler, 2003). This strategy removes a great deal of the abstraction from the model and so makes it easier to apply in an economic assessment.

However, the process of creating a set or basket of goods that is truly equivalent in two different countries is in fact quite difficult. This is true for a number of reasons, including the fact that while a particular good may have the same cost in two different countries, it may not have the same value. This may seem contradictory, but in fact it is not. Let us take the example of diamonds.

In the African nations in which the majority of the world's diamonds are mined, diamonds are valued for their potential (often) to provide arms and to provide power and foreign influence to those who have access to the mines. But because the diamonds are relatively less scarce in these nations than in, for example, the Netherlands or the United States, the way in which people in the different countries assess the value of the diamonds is different.

There is also the very important point that standards of living differ dramatically from nation to nation. If the average person has two sets of clothes in one society and thirty in another, then the parity of price of clothes is hard to assess. It certainly cannot be assessed in terms of the cost alone or the number of outfits that a person "should" have (Taylor & Taylor, 2004).

It might be set at the percentage of annual wages that a person spends on clothing, but even this can be very approximate because of different ideas of what constitutes a sufficient amount of a particular type of good needed for a satisfactory life.

To compensate for the fact that goods can and usually do have different values even when they have the same costs in different countries, economists can use a "relative" version of purchasing power parity in which no absolute value is attempted between certain goods or groups of goods and the only thing that is set at parity is the exchange rate of the two currencies as they are affected by both depreciation and appreciation.

The more similar two nations are, the easier it is to determine (whether by absolutist or relative methods) the parity of purchasing power for residents in those two nations. However, even when the economies and societies in question are relatively equivalent, sometimes a proxy in the form of.