Definition: Purchasing power parity (PPP) is a macroeconomic analysis cadent which correlates the exchange rates of the two countries to match their living standards, gross domestic product (GDP) and economic productivity. PPP theory discourages the idea of making arbitrage profit as a result of varying prices of the same product in two different countries.
This concept functions on the law of one price, i.e., the price of a basket of goods or services would remain constant in different nations.
Content: Purchasing Power Parity (PPP)
Purchasing Power Parity Theory
PPP focuses on eliminating the arbitrage opportunities while selling the same basket of goods in different nations.
Assumption of Purchasing Power Parity Theory
The purchasing power parity approach functions on the Law of One Price. This law assumes that the price of a particular basket of goods in one country remains similar to that in the other country with the exchange of their currencies.
Types of Purchasing Power Parity
Purchasing power parity is a widely applied macroeconomic tool to evaluate the varying cost of living in different countries.
Let us understand the three major kinds of purchasing power parity:
Absolute Purchasing Power Parity
The absolute PPP theory states that a basket of goods has a constant value even when exchanged for two different currencies. This concept emphasizes on converting the currencies of different nations into US dollars.
However, in case there is any variation in the value of goods in two different countries, the currency exchange rate is adjusted over a period to attain a similar price.
Relative Purchasing Power Parity
A slightly modified version of absolute purchasing power parity is the relative PPP concept. Here, the exchange rate of two currencies is considered to change with inflation resulting in different prices of the same product in two countries.
Therefore, the capacity of a currency’s single unit to buy a certain commodity demonstrates the decrease in affordability over a period.
Interest Rate Purchasing Power Parity
In interest rate PPP, the percentage variation in the spot and forward rates is the same as the percentage change in the interest rates of the two countries.
The prevailing exchange rate of the two currencies is called the spot rate. While a future rate is applicable in a forward contract where the currency exchange rate for a future deal is determined at present.
Purchasing Power Parity Formula
The purchasing power parity can be basically calculated through two major formulae as shown below:
Absolute PPP Formula:
S is the Spot Exchange Rate;
P1 is the Cost of Goods X in currency 1;
P2 is the Cost of Goods X in currency 2.
Relative PPP Formula:
St is the Estimate Future Spot Exchange Rate;
S0 is the Initial Spot Rate;
t is the Future Period.
Advantages of Purchasing Power Parity
Since the countries need to deal with one another when it comes to international trade, purchasing power parity eases out the process. Following are the known benefits of PPP:
- Differentiates Quality of Life: Purchasing power parity is a useful parameter to evaluate and compare the quality of life prevailing in different economies.
- Relatively Stable Exchange Rates in Long-Term: PPP is used for adjusting the exchange rates to equalize the value of currencies of the two countries attainable in the long run.
- Comparison of Economic Productivity of Countries: When it comes to the evaluation of economic productivity of two nations through analysis of financial markets and global poverty, PPP is applied.
- Checks Over Trade Imbalances: Cross-border trade i.e., import or export imbalance be corrected by regulating the currency rates to suit the purchasing power of a nation.
- Accurately Determines Country’s Wealth: Purchasing power parity analyzes the gross domestic product of two nations, making it easy to compare their economic wealth.
- Analyzes Global Poverty: The change in exchange rates depict the level of poverty in different nations and together it compounds to global poverty statistics.
- Estimate Government Manipulations: The PPP concept helps to keep a check over the false government practices to appraise the currency’s value or portrait a healthier economy.
Limitations of Purchasing Power Parity
The concept of PPP cannot be applied to all the areas, due to its various criticisms as discussed below:
- Tax Difference: Purchasing power parity overlooks the tax rate difference between the two nations which ultimately impacts the product price in the real world.
- Competition: In some countries, the monopolist take advantage of limited competition and price the goods or services higher than the actual rate.
- Transportation Cost: The cost of importing goods from other countries along with transport cost is considered to be zero which is unrealistic in practice.
- Non-Traded Services: PPP ignores the various indirect costs such as rent, labour, insurance, etc, that varies from country to country.
- Government Intervention: The tariffs imposed by the government of a nation result in price hikes of imported goods, failing the idea of one price.
- Based on Unrealistic Assumptions: As we know, PPP functions over the ‘law of one price’ assumption which is not a practical approach.
- Overlooks Demand and Supply Factors: While demand and supply of goods or services play a key role in determining their price, PPP completely ignores it at the time of foreign exchange rate evaluation.
- Unsuitable in Short-Term: PPP is considered to be fruitful when applied in the long run, however it doesn’t provide any results in the short-term practice.
As the world is turning towards globalization and foreign trade has become a necessity for every nation, purchasing power parity has acquired a crucial place in analyzing the exchange rates in the long run.
Whether its estimation of global inflation, poverty, living standards, economic conditions, etc., PPP is used everywhere.