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Purchasing Power Parity

Purchasing Power Parity

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Published by: mahantesh123 on Feb 09, 2009
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Purchasing power parity
From Wikipedia, the free encyclopedia
Jump to:navigation, search PPP of GDP for the countries of the world (2003). The US is the base country, so it is100. The highest index value, for Bermuda, is 154, so the same goods are 54% moreexpensive in Bermuda than in the United States.
purchasing power parity
) theory uses the long-termequilibriumexchange rateof two currencies to equalize theirpurchasing power. Developed byGustav Casselin 1920, it is based on thelaw of one price: the theory that, in an ideally efficient market,identical goods should have only one price. This purchasing power exchange rate equalizes the purchasing powerof differentcurrenciesin their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparingdifferences in living standards on the whole between nations becausePPP takes into account the relative
cost of living
and the
ratesof different countries, rather than just a nominalgross domesticproduct(GDP) comparison. The best-known and most-used purchasingpower parity exchange rate is theGeary-Khamis dollar(the"international dollar").PPP exchange rates (the "real exchange rate") fluctuations are mostlydue to market exchange rates movements. Aside from this volatility,consistent deviations of the market and PPP exchange rates areobserved, for example (market exchange rate) prices of non-tradedgoods and services areusually lowerwhere incomes are lower. (AU.S. dollarexchanged and spent inIndiawill buy more haircuts than a dollar spent in theUnited States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In otherwords, PPP is the amount of a certain basket of basic goods which canbe bought in the given country with the money it produces. There can be marked differences between PPP and market exchangerates.
For example, theWorld Bank's 
World Development Indicators2005
estimated that in 2003, oneUnited States dollarwas equivalent
to about 1.8Chinese yuanby purchasing power parity
— muchdifferent than the nominal exchange rate that put one dollar equal to7.6 yuan. This discrepancy has large implications; for instance,GDPper capitain thePeople's Republic of Chinais aboutUS$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert thatChina is the world's second-largest economy, but such a calculationwould only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is onlyUS$30,615.
[edit] Explanation
PPP is: £P ($/£)= $P This implies that the exchange rate that equalizesthe value of a dollar of purchasing power (the PPP exchange rate) is:
($/£)= $P/£P
If the actual spot rate is greater, it suggests that the £ is over-valuedagainst the $. If the actual spot rate is less, it suggests that the $ isover-valued against the £.For example if a "representative" consumption basket costs $1,500 inthe U.S. and £1,000 in the UK the PPP exchange rate would be $1.50/£.If the actual spot rate was $1.80/£ this would indicate that the pound isovervalued by 20%, or equivalently the dollar is undervalued by16.7%.
[edit] Relative PPP
Purchasing power parity is often called
purchasing powerparity
to distinguish it from a related theory
purchasingpower parity
, which predicts the relationship between the twocountries' relative inflation rates and the change in the exchange rateof their currencies.Relative PPP relates theinflation rate(the change of price levels) ineach country to the change in the market exchange rate.,where
is thespot ratein Foreign Currency/Domestic Currency and
is the price level in period
(foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasingpower parity.According to this theory, the change in the exchange rate isdetermined by price level changes in both countries. For example, if prices in theUnited Statesrise by 3% and prices in theEuropean Union  rise by 1% the purchasing power of theUSDshould depreciate by 2%compared to the purchasing power of theEUR(equivalently theEUR  will appreciate by about 2%)
[edit] PPP equalization and the law of one price
 Thelaw of one pricestates that differing prices of a traded good willtend to equalize in the absence of tariffs, otherbarriers to tradeand prohibitively highshippingrates. The law of one price can also bestated as: "In anefficient marketall identicalgoodsmust have only one price." The PPPhypothesisis that free trade of goods will alignexchange rates  with their PPP values. However,econometricanalysis rejects thishypothesis, and gives a better prediction of the PPP/exchange rate relationship (theCPI) based on relative GDPs. Neo-classical economicsincludesBalassa-Samuelson effecttheory, which explains the PPPmodel adjustment giving the equilibrium CPIs.
[edit] PPP measurement
 The PPP exchange-rate calculation is controversial because of thedifficulties of finding comparablebaskets of goodsto comparepurchasing power across countries.Estimation of purchasing power parity is complicated by the fact thatcountries do not simply differ in a uniformprice level; rather, thedifference in food prices may be greater than the difference in housing

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