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Purchasing-power parity theory.

A theory which states that the exchange rate between
one currency and another is in equilibrium when their domestic purchasing powers at that rate
of exchange are equivalent.
In short, what this means is that a bundle of goods should cost the same in Canada and the United
States once you take the exchange rate into account. To see why, we'll use an example.

Purchasing Power Parity and Baseball Bats
First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the
exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell
for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15
USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in Mexico, so consumers are
much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to
see three things happen:
1.

American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go
to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw
in "A Beginner's Guide to Exchange Rates" this will cause the Mexican Peso to become more
valuable relative to the U.S. Dollar.

2.

The demand for baseball bats sold in the United States decreases, so the price American
retailers charge goes down.

3.

The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge
goes up.

Eventually these three factors should cause the exchange rates and the prices in the two countries to
change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8
MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball
bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a
consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it
for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.

Purchasing Power Parity and the Long Run
Purchasing-power parity theory tells us that price differentials between countries are not sustainable in
the long run as market forces will equalize prices between countries and change exchange rates in
doing so. You might think that my example of consumers crossing the border to buy baseball bats is
unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat
for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or
thousands of the bats in Mexico then shipping them to the United States for sale. It is also not
unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico
instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United
States and Mexico is not sustainable because an individual or company will be able to gain an
arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other
market (This is explained in greater detail in “What is Arbitrage? ”).
Since the price for any one good should be equal across markets, the price for any combination or
basket of goods should be equalized. That's the theory, but it doesn't always work in practice. We'll
see why on page 2.

The relative version of PPP is calculated as: Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2 Ads Forex Trading Online www. Trade Now! FranklinTempleton Academy www.Definition of 'Purchasing Power Parity .franklintempletonacademy.com/India Buy & Sell Currencies on The Foreign Exchange Market.PPP' An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.easy-forex.com/ Earlier the Better is Important for Investing. Watch & Learn More Now! .

There are three caveats with this law of one price. and other transaction costs.S. is 1. PPP theory implies that the CAD will appreciate (get stronger) against the USD. This process continues until the goods have again the same price. The basis for PPP is the "law of one price". For example. and the USD will in turn depreciate (get weaker) against the CAD. the US Dollar will depreciate against the Canadian Dollar by 2% per year. barriers to trade. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. if Canada has an inflation rate of 1% and the US has an inflation rate of 3%. If the price of the TV in Vancouver was only 700 CAD. For example.00 in a U. (2) There must be competitive markets for the goods and services in both countries. are of course not traded between countries. Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. When a country's domestic price level is increasing (i. immobile goods such as houses. city when the exchange rate between Canada and the U. a chocolate bar that sells for C$1. If this process (called "arbitrage") is carried out at a large scale.50 USD/CDN. it refers to the equalization of price levels across countries. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1. (Both chocolate bars cost US$1.PPP' In other words. inflation rates. (3) The law of one price only applies to tradeable goods.50 CAD/USD. a country experiences inflation). Put formally.. In the absence of transportation and other transaction costs.Investopedia explains 'Purchasing Power Parity .00. that country's exchange rate must depreciated in order to return to PPP. transportation costs. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD. For example.e.) What is Purchasing Power Parity? Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.50 in a Canadian city should cost US$1. consumers in Seattle would prefer buying the TV set in Vancouver. the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency. This proposition holds well empirically especially when the inflation . Absolute PPP was described in the previous paragraph. (1) As mentioned above.S. Relative PPP refers to rates of changes of price levels. the exchange rate between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States PUSA. the US consumers buying Canadian goods will bid up the value of the Canadian Dollar.3 CAD per 1 USD. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. can be significant. that is. competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. thus making Canadian goods more costly to them. and many services that are local. a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.

however. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis. According to PPP. It is also updated once a year to reflect new estimates of PPP. The economic forces behind PPP will eventually equalize the purchasing power of currencies. by comparison. however. A red bar indicates undervaluation of the local currency. How is PPP calculated? The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries.differences are large. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. The PPP estimates are taken from studies carried out by the Organization of Economic Cooperation and Development (OECD) and others. One of the key problems is that people in different countries consumer very different sets of goods and services. A time horizon of 4-10 years would be typical. respectively. Exchange rate movements in the short term are news-driven. This can take many years. the currency is thus expected to appreciate against the US Dollar in the long run. making it difficult to compare the purchasing power between countries. More sophisticated versions of PPP look at a large number of goods and services. the currency is thus expected to depreciate against the US Dollar in the long run. PPP. by how much are currencies overvalued or undervalued? The following two charts compare the PPP of a currency with its actual exchange rate relative to the US Dollar and relative to the Canadian Dollar. . Does PPP determine exchange rates in the short term? No. changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. they should not be taken as "definitive". Different methods of calculation will arrive at different PPP rates. The charts are updated periodically to reflect the current exchange rate. describes the long run behaviour of exchange rates. Announcements about interest rate changes. The currencies listed below are compared to the US Dollar.

A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis. the currency is thus expected to appreciate against the Canadian Dollar in the long run. The currencies listed below are compared to the European Euro. the currency is thus expected to appreciate against the Euro in the long run.The currencies listed below are compared to the Canadian Dollar. the currency is thus expected to depreciate against the Euro in the long run. A red bar indicates undervaluation of the local currency. . A red bar indicates undervaluation of the local currency. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis. the currency is thus expected to depreciate against the Canadian Dollar in the long run.