You are on page 1of 5

1

Canadian
Dollar

= 0.71 USD =

33.38

Philippine
Peso

Purchasing Power Parity
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.
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
BREAKING DOWN 'Purchasing Power Parity - PPP'
In other words, the exchange rate adjusts so that an identical good in two different
countries has the same price when expressed in the same currency.
For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00
in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN.
(Both chocolate bars cost US$1.00.)
A simple example would be a litre of Coca-Cola. If it costs 2.3 euros in France and 2.00$
in the United States then 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 Coca-Cola 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.

Price level ratio of PPP conversion factor (GDP) to market exchange rate
Purchasing power parity conversion factor is the number of units of a country's currency
required to buy the same amount of goods and services in the domestic market as a U.S.
dollar would buy in the United States. The ratio of PPP conversion factor to market
exchange rate is the result obtained by dividing the PPP conversion factor by the market
exchange rate. The ratio, also referred to as the national price level, makes it possible to
compare the cost of the bundle of goods that make up gross domestic product (GDP)
across countries. It tells how many dollars are needed to buy a dollar's worth of goods in
the country as compared to the United States. PPP conversion factors are based on the
2011 ICP round.

Canada

1996-2000

2001-2005

2006-2010

2011-2015

1.3

1.2

1.2

1.1

The Law of One Price says that identical goods should sell for the same price in two separate markets. an ounce of gold should cost the same on commodity exchanges in Chicago and London. no matter how that security is created. When the purchasing power parity doesn't hold. arbitrage profits will persist until the price converges across markets. For example. For example. a burger) in any two countries. It is based on the theory of purchasingpower 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. This assumes no transportation costs and no differential taxes applied in the two markets. where it takes time and effort to move goods physically from one place to another. They would do what is called an arbitrage. the average price of a Big Mac in . Unlike in international trade. BREAKING DOWN 'Law Of One Price' The law of one price exists due to arbitrage opportunities. If the price of a security. then traders would have incentive to purchase the gold on one exchange and sell it at the other one. For example. The law of one price is another way of stating the concept of purchasing power parity. then the total price for each would be the same or else an arbitrage opportunity would exist.Law Of One Price The theory that the price of a given security. Economists generally assume that the law of one price can be applied in liquid financial markets because of the possibility of arbitrage. An economic rule which states that in an efficient market. a security must have a single price. if an option can be created using two different sets of underlying securities. then an arbitrageur will purchase the asset in the cheaper market and sell it where prices are higher. commodity or asset will have the same price when exchange rates are taken into consideration. If the gold costs more on one exchange. commodity or asset is different in two different markets. The Big Mac Index THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. there are very little barriers in global financial markets.

and its actual price gives a supersized measure of currency underand over-valuation. PPP signals where exchange rates should be heading in the long run. in China it was only $2.68 at market exchange rates. Burgernomics was never intended as a precise gauge of currency misalignment. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country. For those who take their fast food more seriously. This adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. given its income per person.93. merely a tool to make exchangerate theory more digestible.America in January 2016 was $4. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. as a country like China gets richer. included in several economic textbooks and the subject of at least 20 academic studies. but it says little about today's equilibrium rate. we have also calculated a gourmet version of the index. Yet the Big Mac index has become a global standard. So the "raw" Big Mac index says that the yuan was undervalued by 46% at that time. .

the World Bank. It was created out of a need to prevent economic crises like the Great Depression. Why the IMF was created and how it works The IMF. To achieve these goals. which has become an enduring institution integral to the creation of financial markets worldwide and to the growth of developing countries. in July 1944. The IMF is responsible for the creation and maintenance of the international monetary system.International Monetary Fund (IMF) The International Monetary Fund (IMF) is an organization of 188 countries. and reduce poverty around the world. It is a specialized agency of the United Nations and is run by its 186 member countries. The IMF will also appraise a country's financial sector and its regulatory policies. working to foster global monetary cooperation. which affect its exchange rate and its government's budget. the system by which international payments among countries take place. Membership is open to any country that conducts foreign policy and accepts the organization's statutes. the IMF focuses and advises on the macroeconomic policies of a country. Created in 1945. The Fund's mandate was updated in 2012 to include all macroeconomic and financial sector issues that bear on global stability. facilitate international trade. out of the Bretton Woods Conference in 1945. What Does It Do? The IMF was born at the end of World War II. also known as the Fund. as well as structural policies within the macroeconomy that relate to the labor . New Hampshire. The IMF's responsibilities: The IMF's primary purpose is to ensure the stability of the international monetary system—the system of exchange rates and international payments that enables countries (and their citizens) to transact with each other. United States. It thus strives to provide a systematic mechanism for foreign exchange transactions in order to foster investment and promote balanced global economic trade. promote high employment and sustainable economic growth. was conceived at a UN conference in Bretton Woods. secure financial stability. The 44 countries at that conference sought to build a framework for economic cooperation to avoid a repetition of the competitive devaluations that had contributed to the Great Depression of the 1930s. the IMF is governed by and accountable to the 188 countries that make up its near-global membership. The International Monetary Fund (IMF) is an international organization that provides financial assistance and advice to member countries. This article will discuss the main functions of the organization. With its sister organization. the IMF is the largest public lender of funds in the world. money and credit management.

Specifically.market and employment. while the World Bank offers assistance in such programs as building necessary public facilities and preventing disease. . Facilitating the expansion and balanced growth of international trade. economy suffers. Promoting global monetary and exchange stability. which occurs when the rates continue to rise. The IMF is more focused on economic policy solutions. The IMF generally monitors the global economy. The IMF vs. the euro of the European Union.S. the World Bank focuses on long-term economic solutions and the reduction of poverty and is funded by both member contributions and bonds. The IMF is thus entrusted with nurturing economic growth and maintaining high levels of employment within countries. their interests are aligned. say. The system of fixed exchange rates was established by the IMF as a way to bolster the global economy after the Great Depression and World War II. and ever since. These exchange rates are set in order to prevent economic collapse. which can occur with runaway exchange rates. and its core goal is to economically strengthen its member countries. The exchange rates established by the IMF allow countries to better manage economic growth and trade relations. or to gold.IMF' Fixed exchange rates. and the opposite is also true. In addition. and they were created together. the IMF was created with the intention of: 1. DEFINITION of 'International Monetary Fund . BREAKING DOWN 'International Monetary Fund . While the IMF provides only shorter-term loans that are funded by member quotas. and although they are two separate entities. 3. This is the familiar system today. as a fund. Assisting in the establishment of a multilateral system of payments for current transactions. This system was abolished in 1971. For example. when the U. which means that the value of a currency can change in relation to the value of another. the World Bank The IMF works hand-in-hand with the World Bank. also known as the Bretton Woods system (named after the original UN conference at which the IMF was conceived). the dollar's value goes down in relation to that of. 2.IMF' The International Monetary Fund (IMF) is an international organization created for the purpose of standardizing global financial relations and exchange rates. it may offer financial assistance to nations in need of correcting balance of payments discrepancies. the IMF has promoted the system of floating exchange rates. refer to the value of a currency being tied to the value of another currency.