Purchasing Power Parity Theory

and its implications, Calculating

actual and implied PPP exchange
rates and its challenges
Presented by:
Nishant Sharma
Panchi Changkakoty
Pradyot Tripathi
Sagar Wakhale

Introduction

The purchasing power parity (PPP)

theory measures the purchasing power
of one currency against another after
taking into account their exchange rate.

Concept

The idea originated with the School of

Salamanca in the 16th century and was
developed in its modern form by Gustav
Cassel in 1918.
The concept is based on the law of one price,
where in the absence of transaction costs and
official trade barriers, identical goods will have
the same price in different markets when the
prices are expressed in the same currency.
Another interpretation is that the difference in
the inflation ratesis equal to the percentage
depreciation or appreciation of the exchange
rate

Functions of Purchasing Power

Parity
2 main functions :
Useful for making comparisons between
countries because they stay fairly constant
and only change modestly.
exchange rates do tend to move in the
general direction of the PPP exchange rate
and there is some value to knowing in which
direction the exchange rate is more likely to
shift over the long run.

Understanding the
theory Simply put what this means is

that a bundle of goods should

cost the same in India and the
United States.
And if this doesnt happen then
we say that purchasing power
parity doesnt exist between the
two currencies.
Lets take an example
Suppose 1 USD is currently
selling for 50 INR.
In US wooden cricket bat sells for
$40 while in India they sell for
INR 750.

Since 1 USD= 50 INR,

the bat which costs
$40 in U.S. costs only
$15 if we buy it in
India.

Clearly there is an
advantage of buying
the bat in India.

3 things to expect next are:

The demand for cricket bats sold in the
United States would decrease and hence its
prices would tend to decrease
The increase in demand for cricket bats in
India would make them more expensive.
Thus the prices in the US and India would
start moving towards an equilibrium.

The Ideal Scenario

The increased demand for INR, for instance
may lead an increase in its value such that 1
USD = 40 INR.
Secondly, due to decrease in demand for the
bats in the US, its price drops to USD 30.
Thirdly, the increase in demand for the bats in
India takes its price up to INR 1200.
At these levels you can see that there is
Purchase Price Parity between both the
currencies.
This also means that whether you buy the bat
in US or in India, it is one and the same thing
for the consumer.

PPP Relationship

S1-So = Ph-Pf
So
1+Pf
S1= 1+Ph
So
1+Pf
If the expected inflation rate in India and U.S. are 6% and
3% respectively. The present spot rate of $1 is INR45.36.
What will be the expected spot rate in 12 months time.
S1
= 1+0.06
45.36
1+0.03
S1= 46.68

Measurement of actual and implied PPP exchange rates

Purchasing power parity is the application of the law of one
price across countries for all goods and services, or for
representative groups (baskets) of goods and services.
PUS = (EUS$/Canada$) x (PCanada)
PUS = price level of goods and services in the US
PCanada = price level of goods and services in Canada
EUS$/Canada$ = US dollar/Canadian dollar exchange rate

E= P/ PF
P is the domestic price index,
PF is the foreign price index,
E is the spot exchange rate (domestic currency units per unit
of the foreign currency)

Implication

A simple example would be a litre of Coca-Cola

If it costs 2.3 euros in France and 2.00$ in the United States

The PPP for Coca-Cola between France and the USA is

2.3/2.00, or 1.15

This means that for every dollar spent on a litre of CocaCola in the USA, 1.15 euros would have to be spent in
France to obtain the same quantity and quality - or, in other
words, the same volume - of Coca-Cola

Implication

purchasing power varies considerably, 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.

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.

Big mac PPP

THE

Big Mac index was invented by The Economist in 1986

as a lighthearted guide to whether currencies are at their
correct level.
It is based on the theory of purchasing-power parity (PPP),
the notion that in the long run exchange rates should move
towards the rate that would equalise the prices of an
identical basket of goods and services (in this case, a
burger) in any two countries
For example, the average price of a Big Mac in America in
July 2014 was $4.80; in China it was only $2.73 at market
exchange rates. So the "raw" Big Mac index says that the
yuan was undervalued by 43% at that time.
The basket is a McDonald's Big Mac, produced in 110
countries.

The Big Mac PPP exchange rate between two countries

is obtained by dividing the price of a Big Mac in one
country (in its currency) by the price of a Big Mac in
another country (in its currency). This value is then
compared with the actual exchange rate; if it is lower,
then the first currency is under-valued (according to
PPP theory) compared with the second, and conversely,
if it is higher, then the first currency is over-valued.
For eg. The price of big mac in India is Rs. 105 and in
the U.S. it is $4.80 so the implied exchange rate is
21.75 and the actual exchange rate is 62.03.
According to big mac index Indian currency is
undervalued by 61.66%.

limitations
In many countries, eating at international fast-food
chain restaurants such as McDonald's is relatively
expensive in comparison to eating at a local restaurant
The demand for Big Macs is not as large in countries
such as India as in the United States.
McDonald's is also using different commercial
strategies which can result in huge differences for a
product. Overall, the price of a Big Mac will be a
reflection of its local production and delivery cost, the
cost of advertising (considerable in some areas), and
most importantly what the local market will bear
quite different from country to country, and not all a
reflection of relative currency values.

Need for adjustment to GDP

The exchange rate reflects transaction values fortraded
goodsbetweencountries in contrast to non-traded goods, that
is, goods produced for home-country use. Also, currencies are
traded for purposes other than trade in goods and services,e.g.,
to buycapital assetswhose prices vary more than those of
physical goods. Also, differentinterest
rates,speculation,hedgingor interventions bycentral
bankscan influence theforeign-exchange market.
PPP exchange rates are especially useful when official exchange
rates are artificially manipulated by governments. Countries
with strong government control of the economy sometimes
enforce official exchange rates that make their own currency
artificially strong. By contrast, the currency's black market
exchange rate is artificially weak. In such cases, a PPP exchange
rate is likely the most realistic basis for economic comparison.

Extrapolating PPP rates

Since global PPP estimates are not
calculated annually, but for a single year,
PPP exchange rates for years other than the
benchmark year need to be extrapolated.[17]
One way of doing this is by using the
country'sGDP deflator. To calculate a
country's PPP exchange rate inGeary
Khamis dollarsfor a particular year, the
calculation proceeds in the following
manner:

DIFFICULTIES
There are a number of reasons that different
measures do not perfectly reflect standards of
living.
Range and quality of goods
The goods that the currency has the "power" to
purchase are a basket of goods of different types:
Local, non-tradable goods and services (like electric
power) that are produced and sold domestically.
Tradable goods such as nonperishablecommodities that can be sold on the
international market (likediamonds).

Trade barriers and nontradables

The law of one price, the underlying mechanism
behind PPP, is weakened by transport costs and
governmental trade restrictions, which make it
expensive to move goods between markets
located in different countries.
As transport costs increase, the larger the range
of exchange rate fluctuations.
According to Krugman and Obstfeld, "Either type
of trade impediment weakens the basis of PPP by
allowing the purchasing power of a given currency
to differ more widely from country to country."

Departures from free competition

Linkages between national price levels are also
weakened when trade barriers and imperfectly
competitive market structures occur together.
This is a reflection of inter-country differences in
conditions on both the demand side (e.g., virtually no
demand for pork or alcohol in Islamic states) and the
supply side (e.g., whether the existing market for a
prospective entrant's product features few suppliers
or instead is already near-saturated). According to
Krugman and Obstfeld, this occurrence of product
differentiation and segmented markets results in
violations of the law of one price and absolute PPP.

Differences in price level

measurement

Measurement of price levels differ from country

to country.
Inflation data from different countries are based
on different commodity baskets; therefore,
exchange rate changes do not offset official
measures of inflation differences. Because it
makes predictions about price changes rather
than price levels, relative PPP is still a useful
concept.
However, change in the relative prices of basket
components can cause relative PPP to fail tests
that are based on official price indexes.