Purchasing Power Parity

12 Key excerpts on "Purchasing Power Parity"

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  eBook - PDF

  International Macroeconomics

  A Modern Approach

  • Stephanie Schmitt-Grohé, Martín Uribe, Michael Woodford(Authors)
  • 2022(Publication Date)
  • Princeton University Press

    (Publisher)

  For these countries, deviations from the law of one price became larger rather than smaller. The figure suggests that there is convergence to the law of one price for rich developed countries such as Canada, Great Britain, Sweden, Switzerland, Denmark, Norway, and the euro area. In these countries the dollar price of the Big Mac was higher than in the United States in 2006, but over the subsequent 13 years the price difference has narrowed significantly. 198 Chapter 9 9.2 Purchasing Power Parity Purchasing Power Parity (PPP) is the generalization of the idea of the law of one price for broad baskets of goods representative of households’ actual consumption, as opposed to a single good. Let P denote the domestic currency price of such a basket of goods and P ∗ the foreign currency price of a basket of goods in the foreign country. The real exchange rate, denoted e, is defined as e = E P ∗ P . The real exchange rate indicates the relative price of a consumption basket in the foreign country in terms of consumption baskets in the home country. When e > 1, the foreign country is more expensive than the domestic country and when e < 1, the foreign country is less expensive than the domestic country. We say that absolute Purchasing Power Parity holds when the price of the con- sumption basket expressed in a common currency is the same domestically and abroad, P = E P ∗ ; or equivalently, when the real exchange rate is unity, e = 1. Ascertaining whether absolute PPP holds requires gathering data on the price of the domestic basket, P, the price of the foreign basket, P ∗ , and the nominal exchange rate, E . Data on price levels of large baskets of goods for many countries is produced by the World Bank’s International Comparison Program (ICP). 2 This data has a frequency of about six years. At the writing of the current edition of this book, the most recent ICP release contains data for the year 2011.

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  The Future of the International Monetary System

  Change, Coordination of Instability?

  • Omar F. Hamouda, Robin Rowley, Bernard M. Wolf(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  7 Purchasing Power Parity as a monetary standard

  Ronald I. McKinnon and Kenichi Ohno

  From its initial formulation by Gustav-Cassel in the unsettling monetary aftermath of World War I, through the modern experience with fluctuating exchange rates since 1973, economists have been fascinated by the relationship between Purchasing Power Parity (PPP) and exchange rate equilibrium. Indeed, Cassel took it as a virtual truism that 'As long as anything like the free movement of merchandise and a somewhat comprehensive trade between two countries takes place, the actual rate of exchange cannot deviate very much from . . . Purchasing Power Parity' (Cassel, 1918, p. 413).

  However, the experience with floating exchange rates in the early 1920s, to be painfully relearned in the 1970s and 1980s, disabused people of the idea that the natural forces of international commodity arbitrage would be sufficient to align national price levels when exchange rates were not fixed. Since 1973, fluctuations in the important yen/dollar and mark/ dollar rates have been unexpectedly large, and seemingly as often away from PPP as towards it. This unpredictability of exchange rates, combined with the natural stickiness of the prices of domestically-produced goods invoiced in domestic currencies, inhibits arbitrage in international markets for manufactured goods so that cross-country prices of very similar products can differ greatly (Isard, 1977; Levich, 1986).

  To explain this anomaly, the modern theory (Frenkel and Mussa, 1980) has it that 'forward-looking' floating exchange rates are determined in asset markets – and continually move according to new information about, say, how policy in country A might change vis-à-vis

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  International Financial Management

  • Geert Bekaert, Robert Hodrick(Authors)
  • 2017(Publication Date)
  • Cambridge University Press

    (Publisher)

  Now that we can calculate the purchasing power of the dollar in two countries, we can examine what happens when we equate the two. 8.2 Absolute Purchasing Power Parity The Theory of Absolute Purchasing Power Parity One version of PPP, called absolute Purchasing Power Parity, states that the exchange rate will adjust to equalize the internal and external purchasing powers of a currency. The internal purchasing power is calculated by taking the reciprocal of the price level, and the external purchasing power is calculated by first exchanging the domestic money into the foreign money in the foreign exchange market and then calculating the purchasing power of that amount of foreign money in the foreign country. Hence, the prediction of absolute PPP for the dollar–pound exchange rate is found by equating the internal purchasing power of a dollar to the external purchasing power of a dollar: ( ) ( ) ( ) = × P t S t P t 1 ,$ 1 ,$ £ 1 ,£ PPP (8.1) where S PPP (t,$/£) signifies the dollar–pound exchange rate that satisfies the PPP rela- tion. By solving Equation (8.1) for S PPP (t,$/£), we find ( ) ( ) ( ) = S t P t P t ,$ £ ,$ ,£ PPP (8.2) Purchasing Power Parity and Real Exchange Rates 318 You should think of absolute PPP as a theory that makes a prediction about what the exchange rate should be given the price levels in two countries. Equation (8.2) predicts that the dollar–pound exchange rate should be equal to the ratio of the price level in the United States to the price level in the United Kingdom. The key here is that differences in prices across countries should be reflected in the relative price of the currencies – that is, in the exchange rate. Later, we examine how well or poorly the theory works by comparing actual exchange rates to the predictions of PPP. First, let’s explore the foundations of the theory of absolute PPP. Goods Market Arbitrage Suppose the internal purchasing power of the dollar is less than its external purchas- ing power in a foreign country.

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  Purchasing Power Parity and Real Exchange Rates

  • Mark P. Taylor(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  locus classicus in Friedman and Schwartz (1963). Since the mid-1906s, the concept appears to have become absorbed, with varying degrees of strictness, into the way many economists think about international macroeconomics and finance. Thus, some 30 years ago, two leading international economists, Rudiger Dornbusch and Paul Krugman, could write: ‘Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate’ (Dornbusch and Krugman, 1976). Twenty years later, another leading international economist, Kenneth Rogoff, could express more or less the same sentiment concerning his professional economist colleagues: ‘most instinctively believe in some variant of Purchasing Power Parity as an anchor for long-run real exchange rates’ (Rogoff, 1996). In fact, however, the two-decade gap in the dating of these quotations was a period during which views on the validity or otherwise of long-run PPP shifted a number of times, as we shall see.

  III.  Purchasing Power Parity: The Algebra

  A central building block of PPP is the law of one price (LOP). The LOP states that once converted to a common currency, the same good should sell for the same price in different countries. In other words, for any good i,

  where Pi is the domestic price for good i, is the foreign price for good i, and Si is the nominal exchange rate expressed as the domestic price of the foreign currency. This expression states that the same good should have the same price across countries if prices are expressed in terms of the same currency. The LOP implicitly assumes that there is perfect competition, that there are no tariff or other trade barriers, and no transportation costs. In practice, due to some or all of these market frictions applying in the real world, the law cannot hold exactly, even if agents assiduously sought to exploit all profitable arbitrage opportunities.

  Absolute

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  The Big Mac Index

  Applications of Purchasing Power Parity

  • L. Ong(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  1 1 Purchasing Power Parity: A Survey of the Issues The Purchasing Power Parity (PPP) doctrine, one of the most widely researched areas in international finance, is also probably one of the most controversial in the theory of exchange rate determination. According to the theory of Purchasing Power Parity, the rate of exchange between two currencies is determined by the differences in the price levels of their respective countries. However, while propo- nents of the theory argue that PPP provides a strong basis for deter- mining exchange rates, others have contended otherwise, with a plethora of empirical research demonstrating persistent deviations from PPP. Consequently, we provide a survey of the issues that con- tribute to the problems in testing the theory. Notably, factors such as the lack of uniformity in the price indices used to determine the long-run equilibrium exchange rate – also known as the ‘index- number problem’ – and the issue of productivity bias, which is prob- ably seen as the most serious criticism of PPP theory, are discussed. We also consider the role of market imperfections as well as structural changes in the economy. Introduction The origins of PPP theory can be traced back to Spanish scholars of the sixteenth century, although the intellectual origins of the doc- trine are credited to Wheatley’s and Ricardo’s work in the nineteenth century. 1 The PPP theory as we know it today, however, is attributed to Gustav Cassel’s writings during the 1920s. Cassel was instrumen- tal in rekindling interest in PPP theory during the modern era, after its demise in the latter part of the nineteenth century. 2 This interest has intensified over the last two decades with the collapse of the Bretton Woods system and the reintroduction of flexible exchange rates in the early 1970s.

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  Measuring Construction

  Prices, Output and Productivity

  • Rick Best, Jim Meikle, Rick Best, Jim Meikle(Authors)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  There are good reasons why we construct special metrics like PPPs to compare prices and performances in different countries rather than using the official exchange rate. One is the volatility of exchange rates. In less than 10 years between October 2001 and August 2011, the Australian dollar (AUD) went from buying USD0.51 to USD1.10 without any fundamental changes to the price level or productivity in either country (fxtop.com 2012). This increase is not evidence of an explosion in the standard of living in Australia. Rather, it is an indication that exchange rates are determined by a number of variables that have very little to do with the price level in either of the countries being compared. In this case, it was the investments caused by the resource boom and the comparatively high rate of interest in Australia.

  Other reasons include differences in relative prices of products in different countries, differences in transport costs and taxes and barriers to trade – domestic and international – market conditions, resources and the like. As an example of price differentials, in July 2013, using the nominal exchange rate, the price of a litre of petrol in Venezuela was EUR0.02, and in Norway the price was EUR2.06, while the cost of a standard room in a five-star, centrally situated hotel was approximately 30 per cent higher in Caracas than in Oslo (MyTravelCost.com 2013). In real terms, this means that the visitor to Oslo gives up the equivalent of about 120 litres of petrol for a night in a good hotel, while his counterpart in Caracas has to give up the equivalent of about 15,000 litres.

  Basic theory

  The basic theory behind Purchasing Power Parity is simple: if a good costs USD1.00 in the USA and AUD1.00 in Australia, the PPP Index (expressed as a ratio) is 1:1 using USA as a base. One USD buys the same in the United States as 1 AUD buys in Australia. If the prices are USD1.00 and AUD2.00, respectively, then the PPP Index is 1:2, or 1 USD buys the same in the United States as 2 AUD buys in Australia. The advantage with this PPP is that we get a metric that is totally independent of the exchange rates and all of the various factors that determine the level and variability of exchange rates.

  The PPP depends on real goods and real resources only, and under the right conditions – it is argued – this PPP index can be extended from one good and two countries to any number of goods in any number of countries. When or if that happens, we have satisfied the conditions of the Law of One Price: the relative prices of goods in any one country are the same as in any other country, and the real exchange rate between any two countries, the PPP, is the same for any collection of goods.

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  Macroeconomics and Markets in Developing and Emerging Economies

  • Ashima Goyal(Author)
  • 2016(Publication Date)
  • Routledge India

    (Publisher)

  Purchasing Power Parity and the exchange rate

  Water finds its own level.

  5.1 Introduction

  In Chapter 4 , we took the expected nominal exchange rate to be given exogenously. In this chapter, we begin to examine more carefully what determines equilibrium real, and therefore expected nominal exchange rates.

  Trade arbitrage between any two countries should lead to a nominal exchange rate that is proportional to the relative price levels of the two countries. This is known as the Purchasing Power Parity (PPP) nominal exchange rate. PPP, thus, links the nominal exchange rate to relative price levels. It implies the bilateral exchange rate between two countries is the ratio of their price levels. The concept has been known for centuries, although it was given its modern name by Gustav Cassel in 1918.1 Although there is little empirical support for PPP, it serves as a benchmark and is a major component especially of the monetary theories of the exchange rate.

  In this chapter, we explain absolute and relative PPP and the underlying law of one price (LOOP). Then, we survey some of the empirical tests of these theories, before turning to reasons why they may fail to hold.

  The remainder of the chapter is structured as follows: Section 5.2 derives PPP and its variants from trade arbitrage. Section 5.3 reports on tests of trade arbitrage and Section 5.4 on why PPP is difficult to establish empirically, before Section 5.5 concludes with a summary of the chapter contents. Appendix 5.A.1 has a formal derivation of the Balassa-Samuelson (BS) result on why the real exchange rate is more appreciated in richer countries.

  5.2 Trade arbitrage

  Just as arbitrage determines equilibrium under UIP, trade arbitrage affects the real equilibrium value of a currency. PPP exchange rate between two currencies is the rate, which would equate the two relevant national price levels if they were expressed in a common currency. That is, the purchasing power of a unit of one currency would be the same in both economies. Since there is no difference between domestic and international purchasing power, parity holds. Under trade arbitrage, a good should have the same price in the same currency in different countries, so that no opportunity for trade arbitrage is left. This is expected to give the value of the nominal exchange rate in the long run. The real exchange rate is then obtained by deflating the nominal exchange rate by relative prices, since this gives the relative price of the foreign good basket in terms of the domestic basket. The real exchange rate is the relative price of two output baskets.

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  Selected Papers Of Lawrence R Klein: Theoretical Reflections And Econometric Applications

  • Kanta Marwah(Author)
  • 1997(Publication Date)
  • World Scientific

    (Publisher)

  This is our interpretation of Purchasing Power Parity in an intuitive limiting sense. The actual mathematical rule that we use is stated below, in terms of export price and exchange rate changes. Some of the controversy centers around the issue whether all goods should follow the law of one price, or only traded goods. Should the principle be studied in level terms or in change terms? It may be asked whether exchange rates and prices actually inter-relate in such a way as to fulfill the equations suggested by the principle. This issue is treated only superficially, in this paper, for the decade of the 1970s. We do not assert that short run variations in exchange rates be explained by Purchasing Power Parity, but we do assert that a detailed exchange rate modeling system should satisfy Purchasing Power Parity in the long run. This does not suggest that the rule has a causal meaning; it merely asserts that the trend equilibrium of a dynamic system should satisfy the doctrine of Purchasing Power Parity. This interpretation of Purchasing Power Parity is much like our interpretation of the quantity of money. We do not look upon the quantity equation as having causal interpretation, yet it appears to hold in the long run. It has been found, for example, that long run simulations of the Wharton Model for the U.S. generate time paths for the jointly dependent (endogenous) variables M2 and PY, money supply and nominal GNP. The two time paths have proportional movement. In this sense, the model projection satisfies the quantity theory principle. Also, we observe that global world data on money supply and GNP move, historically, in accordance with the principles of the quantity theory of money. We do not feel that this establishes a causal pattern, merely that the data follow these joint paths. The same is true of our conception of Purchasing Power Parity for this world simulation.

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  eBook - ePub

  Understanding Chinese GDP

  • Xuguang Song(Author)
  • 2019(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Under the PPP method, if a hamburger costs $4 in New York, this commodity must be similarly priced in Tokyo, Paris, or other places. Multiplying the quantity of hamburgers in Tokyo and Paris by the price of hamburgers in New York yields the value that is calculated according to the PPP. In this way, the outputs between two countries can be compared fairly. If a basket of commodities of the same quantity and quality cost 60 CNY in China or $10 in the United States, then the PPP of RMB against the US dollar is 6:1. In other words, spending $1 on these commodities is equal to spending 6 CNY.

  People often compare the PPPs of different currencies using readily available examples. However, performing an international comparison with the purchasing power of a commodity can lead to a paradox. For example, if a McDonald’s hamburger is sold at 30 CNY in China and $4.5 in the United States, the purchasing power of $1 is appropriately equal to that of 6.6 CNY, which is close to the USD/CNY exchange rate of 1:6.2. Assume that a haircut in New York costs $30 and 20 CNY in Beijing. In this case, the purchasing power of $1 is less than that of 1 CNY. When a Louis Vuitton bag is sold at $200 in the United States and 4000 CNY in China, the purchasing power of $1 is almost equal to that of 20 CNY. In sum, the relative prices of a haircut and luxury commodities deviate far from the exchange rate. Many other similar examples can be found. Therefore, a scientific and rigorous method that can comprehensively evaluate the purchasing power of a currency must be devised, rather than evaluate the relationship between two currencies according to the relative price of a commodity or service.

  4.1.2 Absolute PPP

  Swedish economist Gustav Cassel expounded the PPP theory in 1922 and argued that under the equilibrium condition, the relative purchasing power of two currencies should be reflected in their relative values (Cassel 1922

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  Exchange Rate Economics

  Theories and Evidence

  • Ronald MacDonald(Author)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  2

  Purchasing Power Parityand the PPP puzzle1

  In this chapter and the next we consider the proposition of Purchasing Power Parity (PPP). This concept has been widely used to measure the equilibrium values of currencies and is often the one an economist will first turn to when asked if a currency is over-or undervalued or not. PPP is also a relationship which underpins other exchange rate models, such as the monetary model considered in Chapters 4–6 . In his comprehensive 1982 survey of the PPP literature, Jacob Frenkel referred to the ‘collapse’ of the PPP hypothesis. It is therefore perhaps surprising that since Frenkel’s survey there has been a huge resurgence of interest in the PPP hypothesis. Much of this interest has arisen because of the development of new econometric methods, such as cointegration and non-stationary panel methods, and the application of these methods to testing PPP. The recent PPP literature has produced the so-called PPP puzzle (Rogoff 1996), which concerns the reconciliation of the high short-term volatility of the real exchange rate with the slow mean reversion speed of the real exchange rate. As we shall see in succeeding chapters, the volatility of the real exchange rate can be explained by, inter alia, speculative bubbles, portfolio effects and liquidity effects. The PPP puzzle arises because if it is indeed, say, liquidity effects which drive real exchange rate volatility then the mean reversion speed of the real exchange rate would be expected to be relatively rapid (standard macro-theory suggests that in the presence of sticky prices, the real effects of liquidity shocks on real magnitudes should be dissipated after around 2 years), but in practice mean reversion speeds are painfully slow.2

  In this chapter we start by outlining the PPP hypothesis and then go on to survey the extant empirical evidence on PPP. In terms of the latter, we consider first what we refer to as ‘the early evidence’, that is, empirical estimates conducted in the 1960s through to the 1980s, and then go on to consider more recent empirical tests which rely largely on unit root and cointegration testing. In the next chapter, we focus on the rich variety of explanations offered in the literature to explain the PPP puzzle, and particularly the slow mean reversion speed. These explanations range from the pricing to market behaviour of multinational firms, the role of ‘real’ variables, such as productivity differentials and expenditure effects, and frictions due to transaction costs.

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  Introduction to Foreign Exchange Rates, Second Edition

  • Thomas J. O'Brien(Author)
  • 2016(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 4 Extensions of Purchasing Power Parity

  This chapter extends the connection between goods prices and foreign exchange (FX) rates. First, we cover how inflation rates affect intrinsic FX rates. We’ll apply this idea to understand how FX misvaluations occur when FX rates are fixed. Second, we cover an adjusted version of absolute Purchasing Power Parity (APPP), based on an economy’s per-capita gross domestic product (GDP).

  Relative Purchasing Power Parity

  There is an extension of the international law of one price (ILOP) and APPP conditions that has to do with FX rate movements over time. This dynamic version of the theory relates FX rate changes to relative inflation rates, where “inflation rate” refers to the percentage change in goods prices. The dynamic version is known as the relative Purchasing Power Parity (RPPP) condition. To explain the RPPP idea, we’ll use wheat as the representative good, so the percentage change in the price of wheat in an economy represents the inflation rate.

  Denote the U.S. inflation rate as p$ and the U.K. inflation rate as p£ , noting our convention to use lower case letters for percentage changes. If the bushel prices of wheat at time 0 are and , then the bushel prices of wheat at time 1 will be and , respectively. It may help to think of the inflation rates as pertaining to a unit of time, say, 1 year. For example, assume wheat prices at time 0 of = $2.00 per bushel in the United States and = £1.00 per bushel in the United Kingdom, and that the U.S. inflation rate is 6 percent (per year) and the U.K. inflation rate is 3 percent (per year). Then the new price of wheat in a year will be $2.00(1.06) = $2.12 in the United States and £1.00(1.03) = £1.03 in the United Kingdom.

  The APPP condition says that the spot FX rate at time 0 should be = $2.00/£1.00 2.00 $/£, and that the new spot FX rate at time 1 should be = $2.12/£1.03 2.06 $/£. Despite the appreciation of the pound (and the depreciation of the U.S. dollar), the U.S. dollar/pound spot FX rate is correctly valued in terms of wheat prices at both the beginning and ending times. That is, if the APPP condition holds at both times, there is no FX misvaluation in purchasing power terms, despite the change in the nominal FX price of the currencies. The RPPP condition, in terms of intrinsically correct spot FX rates at time 0 and time N, can be expressed as Equation 4.1 .1

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  Exchange Rates and Macroeconomic Dynamics

  • P. Karadeloglou, V. Terraza, P. Karadeloglou, V. Terraza(Authors)
  • 2008(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Part I The Purchasing Power Parity and its Implications for Equilibrium Exchanges Rates 1 Three Exchange Rate Puzzles: Fact or Fiction? Ronald MacDonald 1.1 Introduction In their provocative paper, Obstfeld and Rogoff (2000) advocated explaining six key puzzles in International Finance by appealing to transaction costs. Their paper has generated a large and vibrant liter- ature which seeks to establish if indeed transaction costs explain the puzzles. In this paper we examine two of the puzzles addressed in Obstfeld and Rogoff, namely the PPP puzzle and the exchange rate disconnect. We argue that the latter actually has two puzzles sub- sumed within it, what we refer to as the levels and volatility puzzles. Hence, in total, we explore three puzzles in this paper. A common conclusion often expressed regarding the puzzles is that they cannot be understood in terms of a standard macroeconomic framework and therefore to understand exchange rate behaviour the profession has to move towards a market microstructure approach and effectively abandon macroeconomic fundamentals (see for example, Flood and Rose (1995». The bottom line in this paper is, however, that macroeconomic fundamentals are useful for explaining exchange rate behaviour and indeed can be used to explain the exchange rate puzzles. The so-called PPP puzzle (Rogoff (1995)) concerns the high volatil- ity of real and nominal exchange rates and the slow mean reversion of real exchange rates. The ballpark figure for the latter is within a range of three - five years for CPI-based real exchange rates. The puz- zle arises because the exchange rate volatility is consistent with a standard price stickiness story (Le. liquidity effects in the presence of 9

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