Purchasing power parity

In economics, purchasing power parity (PPP) is a method used to calculate an alternative exchange rate between the currencies of two countries. The PPP measures how much a currency can buy in terms of an international measure (usually dollars), since goods and services have different prices in some countries than in others.

Method

The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.

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A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US and GBP£3 in Britain, the PPP exchange rate would be £3 for $4. In the same way, if a Big Mac or any basket of goods costs USD$4 in the US, the PPP exchange rate is always GBP£3 for $4.

Related Topics:
Big Mac index - The Economist - Big Mac - McDonald's - USD - GBP - Exchange rate

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Relative PPP

Relative PPP is concerned with change of price levels over different periods, also known as inflation rate. The equation looks like rac{S_t}{S_{t-1}}=rac{P_{t}^*/P_{t-1}^*}{P_{t}/P_{t-1}}, where S_t is the spot rate and P_t is the price in period t (foreign values are marked by an asterisk). The change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European union rise by 1% the PPP of the USD has to depreciate by 2% compared to the PPP of the EUR (or alternatively the EUR will appreciate by 2%).

Related Topics:
Inflation - Spot rate - United States - European union - USD - EUR

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PPP equalization and the law of one price

The law of one price states that prices of traded goods will equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates.

Related Topics:
Law of one price - Tariff - Barriers to trade - Shipping

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The naïve PPP hypothesis is that free trade of goods should revert exchange rates to their PPP values. However, econometric analysis rejects this hypothesis, and gives a better prediction of the PPP/exchange rate relationship (the CPI) based on relative GDPs. Neo-classical economics includes Balassa-Samuelson effect theory, which explains the PPP model adjustment giving the equilibrium CPI.

Related Topics:
Hypothesis - Exchange rates - Econometric - Exchange rate - CPI - Balassa-Samuelson effect

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For more discussion, see discussion and clarification of PPP.

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