Purchasing Power Parity (PPP) – Its Merits and Demerits

PURCHASING POWER PARITY (PPP) – ITS MERITS AND

DEMERITS.

KABWE CHIPOPOLA

INTERNATIONAL FINANCE

MSc. Economics

1
 Purchasing Power Parity (PPP) – Its Merits and Demerits

TABLE OF CONTENTS

1.0.0 INTRODUCTION…………………………………………………….………1
2.0.0 THE MERITS AND DEMERITS OF PPP…………….……………………..2
2.1.0 THE MERITS OF PPP...………………………………………………….......2
2.1.1 Stability…………………………...……………………………………….......2
2.1.2 Gross Domestic Product….………………...…………….................................2
2.1.3 Trade Balances……………..………….…..…………………………………..3
2.1.4 Changes in Exchange Rates…………………………………………………....3
2.1.5 Monetary Approach………………………………….……...............................3
2.2.0 THE DEMERITS OF PPP….. ………………………….………………..........4
2.2.7 EMPIRICAL EVIDENCE………………………………………………..…....6
3.0.0 EVALUATION AND USEFULNESS ………………………………………..6
4.0.0 CONCLUSION………………………………………………………………...7
REFERENCES……………………………………………………………………….8
WEBSITES……………………………….…………………………………………..8
BIBLIOGRAPHY……………………….……………………………………………8
APPENDIX…………………………….……………………………………………..9

2
 Purchasing Power Parity (PPP) – Its Merits and Demerits

1.0 INTRODUCTION
By definition, the Purchasing Power Parity (PPP) is a unit of measurement that allows
comparison of purchasing power of different currencies. In its calculation, the
purchasing power parity does not take into account the exchange rate but the cost of
living in general through a basket of goods and services. So, we compare for example the
price of a bottle of Coca Cola in France and in the United States. Unlike the exchange
rate that reflects the value of a currency on the market, the PPP emphasizes the intrinsic
value to a consumer.

According to Krugman (2009), PPP theory further predicts that a fall in a currency’s
domestic purchasing power will be associated with proportional currency depreciation in
the forex market. Conversely, the theory predicts that an increase in the currency’s
domestic purchasing power will be linked to a proportional currency appreciation. Using
simple notation, suppose P1 is the Yen price of a commodity basket sold in China and P2
the euro price of the same basket in Europe, then, assuming that a single basket correctly
measures money’s purchasing power in both nations, we have a Yen/euro exchange rate
as:

Eyen/euro =P1/P2 or P1= Eyen/euro X P2

From above given formula, the PPP theory thus asserts that the two prices are the same
because both countries’ (China and Europe) price levels are equal when measured in
terms of the same currency. In addition, above equation also resembles the law of one
price. However, Rose and Marquis (2012) state that the difference between PPP and the
law of one price is that the latter applies to individual commodities while PPP applies to
general price level which is a composite of the prices of all the commodities that enter
into the reference basket. Law of one price is actually a building block for PPP, as it
states that single price must be the same anywhere in the world in the absence of trade
barriers and under free competition conditions. According to Munzer (2009), there exists
two versions of PPP, absolute and relative. In actual sense, the law of one price illustrates
absolute PPP while relative PPP is the measure of changes in purchasing power
between two countries, which is also the variation of the PPP between two periods.

This paper discusses the merits and demerits of the Purchasing Power Parity Theory as
well its importance and usefulness amidst interactions between countries’ exchange rates
and desired outputs.

3
 Purchasing Power Parity (PPP) – Its Merits and Demerits

2.0.0 THE MERITS AND DEMERITS OF PPP THEORY

While there has been much controversy about the general validity of this theory, it
does highlight important factors behind exchange rate movements. Furthermore,
the basic idea is that a good or service should cost about the same in one economy as in
another. When this doesn't happen it means that either one currency is overvalued or
another undervalued. Economists take advantage of this law to observe distortions in
markets from inflation and government interference. Below is the discussion on the
advantages and drawbacks of the PPP theory:

2.1.0 THE MERITS OF PPP

2.1.1 Stability

The main advantage is that PPP exchange rates remain stable over time.
Discovering the difference between purchasing power in different economies
helps scholars to observe differences in the quality of life. Krugman (2009) also
contends that even if the currency of a country has become severely devalued, it
may not have very wide effects on the majority of citizens as long as their
purchasing power remains near parity for domestic goods. Even if the currency
fluctuates in the short term, purchasing parity hopefully remains over the long
term. See Figure 2 in the Appendix on Page 8.

2.1.2 Gross Domestic Product (GDP)

Finding gross domestic product (GDP) provides a good general way to measure
the wealth of different economies. Unfortunately, if an economist calculates GDP
with the standard domestic currency rates, it can lead to an inaccurate picture.
Experts often point to the example of China, which intentionally devalues its
currency. By adjusting for the assumed purchasing parity that China has with the
United States, economists can provide a more accurate idea of the nation's wealth.

2.1.3 Correcting Trade Imbalances

When a severe trade imbalance develops between a nation's exports and its
imports, economists may propose a variety of remedies. A common proposal is to
erect trade barriers which may further distort markets. If, however, economists can
observe a difference between a nation's purchasing power and its currency rate, the

4
 Purchasing Power Parity (PPP) – Its Merits and Demerits

imbalance becomes much simpler to correct. Readjusting the currency to match

actual purchasing power can solve the problem without excessive government
involvement.

2.1.4 Long Term Changes in exchange rates

The theory also explains what determines the balance of payments itself.
According to Rose (2012), it shows that trade and payment between countries
change mainly due to changes in relative price levels of the countries concerned In
the long run; therefore, the exchange rates depend on relative prices and price
changes. The theory has its importance when price movements are a significant
factor affecting exchange rates. But when price fluctuations are not so important,
the theory has little significance.

2.1.5 Monetary approach to exchange rate.

Another advantage of PPP is that when combined with money, demand and
supply, PPP leads to a very useful theory of how exchange rates and monetary
factors interact in the long run. This theory is called monetary approach to the
exchange rate. This approach generally predicts that the exchange rate is fully
determined in the long run by the relative supplies of those monies and the relative
real demands for them. Other notable and useful predictions of this approach are
shown in figure 4 of the appendix on page 9

2.2.0 THE DEMERITS OF PPP

2.2.1 The theory proposes a direct functional relation between the purchasing
powers of the currencies of two countries and their exchange rate. However, in
reality there is no such direct and precise link between the two. There are many
factors apart from the purchasing power of currencies, such as tariff, speculation,
capital flows, cost of living and wholesale price index numbers etc., which
significantly affect the rate of exchange. Moreover, Krugman (2012) argues that
price indices in different countries are not comparable, as they are constructed on
different bases and differ in respect of the base period, representative commodities
included weights assigned to different items and the method of averaging. Also,
since inflation data in different countries is based on different commodity baskets,
it is not possible for exchange rates to cancel out inflation variations even if
barriers of trade are non-existence and products are tradable.

5
 Purchasing Power Parity (PPP) – Its Merits and Demerits

2.2.2 According to Curry (2013), the purchasing power parity theory may hold
good only in case of prices of goods entering into the foreign trade, but it is
illogical to apply it in terms of general indices as there cannot be any direct
relation between the internal and international prices of good just confined to only
domestic markets of the trading countries. The Keynes theory, therefore, remarks
that" confined to internationally traded commodities, the purchasing power parity
theory becomes an empty truism."

2.2.3 The theory assumes that, we are dealing with a similar group of commodities
in both countries. This assumption is not tenable, when the very base of
international trade is geographical specialization in production. Moreover, the
concept of a change in the price is vague in theory. Prices of all commodities
never move uniformly. Prices of some commodities rise or fall much more than
those of others. Under such conditions, no simple comparison can be made
between the price movements in different countries.

2.2.4 Another drawback of the theory is that it fails to take into consideration any
items in the balance of payments other than merchandise trade. That is to say, the
purchasing power parity theory applies at best only to current account transactions,
neglecting capital account completely. Craig (2005) states that, purchasing power
parity theory is designed for trader nations and gives little guidance to a country
which is both a trader and a banker.

2.2.5 The theory assumes free trade and absence of exchange control for a steady
exchange rate based on PPP. In reality, however, state intervention in the free flow
of international trade such as export duties, import duties, import quotas or import
licensing and exchange control devices cause a permanent deviation from the rate
of exchange determined by relative price levels -the purchasing power parity.
Also, according to Krugman (2012), contrary to the assumption of the law of one
price, transport costs and restrictions on trade certainly do exist. These trade
barriers may be high enough to prevent some goods and services from being
traded between countries. See numerical illustration of this example in figure 1
of the Appendix on page 8.

2.2.6 Rose and Marquis (2012) conclude that: "Purchasing power parities cannot
be used to compute equilibrium rates or to gauge with precision deviations from
international payment equilibrium." At best, purchasing power parities can be used

6
 Purchasing Power Parity (PPP) – Its Merits and Demerits

for finding the approximate rang with which the equilibrium rate of exchange can
be located. The actual application of the purchasing power parity doctrine for
calculating the exchange rate has proved that it cannot give a correct forecast of
the equilibrium exchange rates. Thus, theory cannot be useful for calculating with
precision the actual equilibrium exchange rates.

2.2.7 Empirical Evidence: PPP and Law of one price

In addition to the demerits that have so far been discussed, it is also important to
establish whether or not PPP can explain actual data on exchange rates and
national price policies. Empirical support for PPP and Law of one price is rather
weak, as shown in recent historical data. Support for PPP is also weak due to the
above given demerits that have been already been discussed at length. See figure 3
on page 9 in the appendix that gives an illustration of empirical evidence on
PPP weaknesses.

3.0.0 EVALUATION AND USEFULNESS OF PPP

3.1.1 Despite various limitations mentioned above, PPP is the only sensible
explanation of long-term changes in exchange rates under all monetary conditions,
gold standard, etc. it explains the working of a long-term tendency in exchange
rates, which has an important bearing on practical policy in regard to foreign trade
and payments.

3.1.2 The purchasing Power Parity reflects an economic reality and so removes
the speculative aspect that significantly affects the market exchange rates.
Comparisons are also possible in the short term. With the market exchange rate, it
is better to observe the general trend because due to volatility, there are sudden
changes of quotes that they do not appear in the PPP exchange rate (Rose and
Marquis 2012).

3.1.3 The purchasing Power Parity exchange rate allows the comparison with
poor countries. Indeed, it is difficult to get an objective view of the evolution of a
poor country compared to a rich country (or other poor countries) because
currencies of these countries are often undervalued (as unattractive for investor).
Moreover, some of these countries still have a fixed exchange rate. The price of
their currency is pegged to the evolution of another currency (usually U.S.
dollars). It is impossible to make an assessment of the evolution of living when the

7
 Purchasing Power Parity (PPP) – Its Merits and Demerits

exchange rate does not fluctuate. However, the PPP theory allows for this to
happen.

3.1.4 Because purchasing power varies considerably, Curry (2013) stated that PPP
provides insight on the potential overvaluation or undervaluation of a nation's
currency. This is important because currencies that are over or undervalued
according to PPP are likely to correct over time, leading to potential economic
impacts and long-term fluctuations in the exchange rate. PPP helps provide some
predictability to these economic impacts. For example, a local currency
determined by PPP to be significantly overvalued can be expected to depreciate
against widely traded currencies like the U.S. dollar over the long run.

3.1.4 According to Craig (2005), Purchasing power parity is important for

developing reasonably accurate economic statistics to compare the market
conditions of different countries. For example, purchasing power parity is often
used to equalize calculations of gross domestic product. Because purchasing
power can vary from country to country, the statistic for GDP based on purchasing
power parity is often different than nominal GDP. GDP as described by currency
exchange alone.

4.0 CONCLUSION

National price levels play a key role in determining both interest rates and the
relative prices at which countries’ products are traded. PPP theory explains how
national price levels for trading nations interact with exchange rates so as to
understand why exchange rates can change dramatically over periods of time. That
means that to compare the data, each country’s statistics must be converted into a
common currency. The theory has its importance when price movements are a
significant factor affecting exchange rates. But when price fluctuations are not so
important, the theory has little significance. Despite its shortcomings, it explains
the working of a long-term tendency in exchange rates, which has an important
bearing on practical policy in regard to foreign trade and payments.

8
 Purchasing Power Parity (PPP) – Its Merits and Demerits

REFERENCES

1. Callen, Tim (2013). “PPP: Weights Matter,” Journal /alexander

becher/dpa/corbis
2. Rose, Peter S; Marquis, Milton H (2012), “ Money and Capital Markets (10th
edition),” Financial Instruments and Instruments in a Global Market
place,McGraw and Hill,
3. Krugman, Paul R; Obstfeld, Maurice (2009), “ International Economics Theory
and Policy (8th edition), Pearson Education.
4. Craig, Valentine V (2005). “ China’s opening to the world: what does it mean
for US Banks?” FDIC Banking Review, Vol 17, No 3.
5. Curry, Timothy (2013). “ Assessing International Risk exposures of Foreign
Banks,” Journal review.
6. Marc Munzer (2009). “Purchasing Power Parity - its theoretical perspective
and empirical evidence,” Munich, GRIN Verlag.

WEBSITES

1. www.forexlearningcentre.com
2. http://www.ehow.com/info_8425677_importance-purchasing-power-
parity.html
3. http://www.grin.com/en/e-book/133689/purchasing-power-parity-its-
theoretical-perspective-and-empirical-evidence

BIBLIOGRAPHY

1. Krugman, Paul R; Obstfeld, Maurice (2009), “International Economics Theory

and Policy (8th edition), Pearson Education.
2. Hongfei, J (2015). “Lecture Notes (ppt) on International Finance, “Shanghai
University of Finance and Economics (SUFE), School of Finance.

9
 Purchasing Power Parity (PPP) – Its Merits and Demerits

APPENDIX

Figure 1: calculation on trade barriers and non-tradables as a criticism on PPP.

Suppose that a sweater sells for $45 in New York and for £30 in London but it costs $2 to ship a
sweater between the two cities. At an exchange rate of $1.45 per pound, the dollar price of a London
sweater is ($1.45 per pound) x (£30) =$43.50, but an American importer would have to pay $43.50 +
$2 = $45.50 to purchase the sweater in London and get it to New York. At an exchange rate of $1.45
per pound, it therefore would not pay to ship sweaters from London to New York, even though their
dollar price would be higher in the latter location. Similarly, at an exchange rate of $1.55 per pound,
an American exporter would lose money by shipping sweaters from New York to London even though
the New York price of $45 would then be below the dollar price of the sweater in London, $46.50.

SS
Source: Krugman (2009)

Figure 2: Comparing Economies using PPP: Is China catching up with USA?

Another way of comparing economies, employed by the ICP, uses a concept called purchasing power parity. PPP
exchange rates make adjustments for the differing costs of goods and services across countries. They attempt to show
what exchange rates would have to be to buy the same basket of goods in different places. As costs are much higher in
the industrialized world, especially for non-traded goods, comparisons of GDP by PPP exchange rates tend to boost the
relative size of poorer nations’ economies. In essence, money goes further in the developing world. PPP is useful as a
way to get at hidden advantages developing nations have. For instance, it costs the Chinese government much less to
pay its soldiers than it does the U.S. government to pay GIs. Tourists from rich countries intuitively reflect on PPP
when they visit poor ones and buy dinner, thinking, “Geez, my dollar goes farther here.” “The advantage of using GDP
at PPP rates is that it better measures welfare, and also PPPs tend to be more stable and thus the $GDPs of countries
(used for international comparisons, etc.) don’t jump around as much,” Markus Rodlauer, chief of the IMF’s China
mission, wrote in an email.

10
 Purchasing Power Parity (PPP) – Its Merits and Demerits

Figure 3: Empirical Evidence on PPPand law of one Price

Above figure shows PPP’s weaknesses by plotting both the yen/dollar exchange rate and the ratio of the Japanese and
US price levels through 2006. Price levels were measured by indexes reported by the Japanese and US Governments.
PPP predicts that the yen/dollar exchange rate and the Japan/USA price levels must move in proportion burt clearly
they do not. In 1980s there was a steep appreciation of the dollar against the yen, even though, with Japanese yen’s
price level consistently falling relative to that in the USA. The same inflation trends continued after mid 1980s

Figure 4: useful Predictions of the monetary approach to the exchange rate

Source:IMF(2012)

11