Understanding the Meaning of Purchasing Power Parity in 2022

The success of trading on the forex market implies the ability to correctly determine the most successful trades. And here you can't do without the methods of forecasting further currency movement. However, to make accurate forecasts, it is necessary not only to have skills in technical analysis of the market - but it is also vital to understand and be able to analyze the fundamental factors that affect the currency rate. The most important of them is the general economic conditions that characterize the country's position in the global financial market and affect the change of the national currency rate in the long run. The ideal exchange rate is considered to be the rate of purchasing power parity. So, that is what we will talk about today.

What is Purchasing Power Parity?

The concept of purchasing power parity emerged and developed as a theory of determining exchange rates. As a rule, its creator is usually called Swedish economist and professor at Stockholm University Gustav Cassel. Cassel's theory was purely practical. The fact is that under the conditions of the new world financial system that emerged after the end of World War I, with the abolition of the gold standard there was an urgent need for new, "right", ratios of currencies between different countries, regardless of the possibility of their exchange for precious metals. In the early version of the theory, Kassel suggested that the value of the exchange rate between currencies in free trade conditions was determined by the ratio of their purchasing power. The idea behind this definition of the exchange rate seems to have been that, according to the primary function of funds - to act as a means of exchange - the desire of economic agents to exchange one currency for another must be directly related to how many goods and services can be bought with it in the country concerned. Thus, the original idea of the theory of purchasing power parities of currencies was that the value of the exchange rate of currencies depends directly on their internal purchasing power in the territory of the issuing countries, and the "coefficient between the purchasing power of currencies" itself was called purchasing power parities.

Cassel assumed that if the free trade conditions were violated, the exchange rate could deviate from the purchasing power parity of the currencies, although it was believed that this deviation would not be very significant and would be short-lived.

It is this version of the concept, called absolute purchasing power parity, that is chronologically the earliest version of the theory. It has caused a great number of disputes practically since its appearance, but it is on this basis that the concept of purchasing power parity is used in the practice of international comparisons. Although the absolute purchasing power parity turned out to be more "popular", a few years after the introduction of the term into scientific circulation, Cassel moved quite far from the original formulation and switched to the so-called concept of relative purchasing power parity.

In general, purchasing power parity may include several currencies and goods. Basically, it is the amount of one currency, expressed in units of another currency, needed to purchase the same product or service in both markets., it states that each commodity traded freely will have the same price anywhere in the world if the same price is specified in the common currency. Everything seems to be clear.

The purchasing power parity itself cannot be a working theory, if only because of the cost of logistics and transaction costs. After all, in real life, the goods need to be moved, which increases their price. The same applies to the currency in forex, where there are these very trade costs, spreads, commissions, and so on. Depending on the situation, the basket of goods, prices, taxes, tariffs, etc. will form a more realistic price relative to the rate.

Since the functioning of the purchasing power parity model is possible only under conditions of free movement of goods and currency, in practice exchange rates usually deviate significantly from parity. Besides, the demand for one or another currency on the exchange depends on many other factors.

Examples of using purchasing power parity in life:

• Various international organizations (World Bank, Eurostat) publish economic indicators for different countries in a single currency (most often in U.S. dollars) using exchange rates based on purchasing power parity.
• A popular example of the use of purchasing power parities is the "Big Mac Index," regularly calculated and published by the English weekly The Economist. The index is calculated based on "Big Mac" prices at McDonald’s restaurants in different countries and is an alternative exchange rate.
• Another less known index, the "iPod index", is calculated by the Australian investment bank Commonwealth Securities based on the prices of the popular Apple MP3 player in different countries.

What is the Law of One Price?

The law of one price states that in competitive markets, in the absence of transportation costs and official trade barriers (such as duties), the same goods shall be sold in different countries for the same price if this price is expressed in the same currency.

When trade is unhindered and cost-free, the same goods should be sold at the same relative prices regardless of where they are sold. We recall this principle here because it forms one of the links between the national prices of goods and exchange rates.

There is, however, a difference between the purchasing power parity and the law of one price: the law of one price applies to individual goods, and the purchasing power parity to the general price level composed of the prices of all goods in the consumer basket. If the law of a single price is fair for each product, the purchasing power parity must be complied automatically as long as the consumer baskets used to calculate the price levels of different countries remain the same.

Supporters of the purchasing power parity theory argue, however, that its validity (in particular, its validity in the long term) does not require that the law of the one price be precisely followed. They claim that even if the one price law is not followed for each commodity, prices and exchange rates should not deviate too far from the ratio determined by the purchasing power parity. When goods and services temporarily become more expensive in one country than in others, the demand for that country's currency and its products drops, pushing the exchange rate and domestic prices back to a level corresponding to the purchasing power parity.

The Law of One Price: Example

So, how does the law of one price manifest itself in real life? How can it affect the currency rates, i.e. forex?

For example, we can consider a hypothetical situation with the use of a single product: let's imagine that a loaf of bread in India costs 30 rupees, and in the United States - 2 dollars. It turns out that the dollar rate to rupee should be at 15 rupees per dollar. But if the real exchange rate is 25 rupees/1 dollar, one can buy bread in India at the price of 30 rupees and sell it in the United States for 2 dollars and then exchange two dollars for 50 rupees at the real exchange rate. In such a way, one can get a return of 20 rupees for each loaf, that is, a unit of goods.

Based on forex education and the law, the price of bread in the United States will go down, but in India, on the contrary, it will go up. So, the dollar-rupee exchange rate will go down. So, what will happen in the end? It is likely that at the end of the day, we will see equilibrium and a new rate.

So what does PPP mean?

Purchasing power parity is the economic indicator that most accurately characterizes the state of economies in different countries. It allows comparison of the "value" of different national currencies and is directly related to prices: if prices rise, the purchasing power drops (and vice versa).

What is Absolute Purchasing Power Parity?

Absolute purchasing power parity states that if you take a basket of goods in one country and compare its price with the price of an identical basket of goods in another country by converting it into one of the currencies, the prices of these baskets of goods will be the same. That is, if the price level in a country increased by 50% and the price level in a country remained the same, the value of the currency of country A (expressed in the currency of country B) should decrease by 50%. If the price level in A increases by 60% and B - by 25%, the price of currency A will decrease concerning currency B only by 28%.

According to the theory of absolute parity, an increase in the level of domestic prices relative to the level of prices abroad will result in a proportional depreciation of the national currency relative to foreign currency.

The value of the theory of absolute purchasing power parity is that it clearly indicates one of the most important sources of depreciation of the national currency - domestic inflation in the country, and thus, one of the ways to stabilize the exchange rate - to contain inflation and strengthen the purchasing power of the national currency within the country.

Drawbacks of the theory of absolute purchasing power parity:

• It is very difficult to make identical baskets of homogeneous goods sold in different countries and to measure the price of these baskets;
• the problems of using this theory are related to the unrealistic assumptions on which it is based. In practice, the process of price equalization is complicated by trade barriers, transportation, and transaction costs, as well as by the fact that not all goods are tradable, not all currencies are convertible, etc.

What is Relative Purchasing Power Parity?

Relative purchasing power parity means that changes in exchange rates will be proportional to changes in relative price levels in the two countries. The essence of relative purchasing power parity is that changes in the exchange rate over a given period will be proportional to the relative changes in price levels in the two countries over the same period.

If inflation in a given country is higher than abroad, other things being equal, the national currency should tend to depreciate in the long run. In fact, predicting the exchange rate based on relative parity means extrapolating the current rate for the future period based on the inflation rates in the two countries.

Since rates based on the theory of relative purchasing power parity deviate from current market rates, the idea has emerged that when currencies deviate from parity, they are "overvalued" or "undervalued". A currency is considered overvalued if its real exchange rate rises faster than the one calculated based on purchasing power parities and underestimated if it rises slower. The exchange rate assessment from this point of view has a serious practical value: the overvaluation of a national currency, even taking into account a very tentative indicator such as purchasing power parity, is usually seen as a factor negatively affecting export growth.

Thus, at a fixed exchange rate, the country will have to artificially devalue the currency to return trade to the same level.

At the same floating rate, which takes place in most developed countries, investors can continue to invest in a country with a deficit, but only with compensation in the form of high-interest rates. And too high-interest rates lead to inflation one way or another. Sooner or later the basket of goods in the first country will reach parity in price with the same basket in the second.

This is the scenario that is meant by purchasing power parity, and, at first glance, everything is logical here. Each year, The Economist magazine publishes comparative data on the price of "big mac", which gives rates of different currencies in dollars, which should have taken place for the price parity of a burger in 80 countries. The study also compares the rates of currencies with the pound, euro, yen, and yuan in this regard.

The point here is this: if "big mac" costs more in a country 1 than in others, the currency of that country is overvalued, if less, it means that the currency is undervalued. Quite often, the overvalued currency for the next year is declining, while the undervalued one is growing. Organizations such as the World Bank and other large banks also calculate purchasing power parity. This parameter is also monitored by the European Commission (in terms of price convergence).

Simple Relative Purchasing Power Parity Example

Let us have a look at the example, so it is crystal-clear. Let's say the total price level in Country B remains unchanged from the base period to period "1", while the total price level in Country A increases by 50 percent, the theory of relative purchasing power parity states that the exchange rate for Country A's currency to Country B's currency (defined as the number of units of currency of Country A per unit of currency of Country B) should increase by 50 percent (i.e., the currency of Country A should depreciate by 50 percent) in period "1" compared to the base period.

Note that when the theory of absolute purchasing power parity is correct in predicting the exchange rate, the theory of relative purchasing power parity is also correct, but when the theory of relative purchasing power parity is correct, it does not mean that the theory of absolute purchasing power parity is also correct. For example, while the very existence of capital flows, transportation costs, and other impediments to the free flow of international trade and government regulation policies cause the theory of absolute purchasing power parity to be abandoned, wrong conclusions can only be drawn using the theory of relative purchasing power parity if all these parameters change.

Disadvantages of Purchasing Power Parity

The main problem of the theory is that this parity was invented by economists. This balance is simply unattainable in reality. Let's start with the fact that in many countries prices in some sectors and for some goods are kept at a low level due to objective factors. For example, the production of grain crops in the United States will always be cheaper than in Japan due to the fertile soil and better climate. Emerging markets in Asia, including China, enjoy cheap labor costs, especially concerning clothing production. It will take several decades (if at all possible) to smooth out all these "irregularities". It will be very difficult to find the correlation between the automobile industry of the USA and Germany and corresponding exchange rates. According to the theory of purchasing power parity, there shouldn't have been export growth in Germany, but it did happen.

Next: we don't even have clear units of measurement. What is, after all, this "basket of goods"? For an average Japanese firm or household, this basket will be one, and for the same firm or household in Britain, France, and the United States, another. An attempt to bring such a basket "to a common denominator" is doomed to failure: firstly, many will have to neglect (for example, the difference in the quality of goods), and secondly, the data will always be outdated. Thus, for example, in the U.S., recently increased demand for handmade goods, whether soap or clothes, and such goods, respectively, will be more expensive. In Japan, local rice is considered much better than American or any other rice. Such quality factors are primary for relative value.

The next point is that many services are provided only at the local level and are not transferred across national borders. General hospitality, beauty services, and repair crews are all done locally. At the same time, services make up a huge share of the economy in many countries - in the United States, for example, 65 percent. Whether the dollar rises against other currencies or falls, in terms of payment and the price of such services is absolutely irrelevant.

The law of purchasing power parity does not work even in the conditions of one country, what can be said about the international currency market forex, where the trader earns within the boundaries of the planet. The relative weakness of this theory is that it implies free trade in goods without tariffs, quotas, and taxes. Thus, if the U.S. announces new import duties, the prices of domestically produced goods will rise. However, this increase is not reflected in the tables of the purchasing power of the dollar.

Another disadvantage is its application to a limited standard set of goods, but not to services where there are significant price differences. Moreover, many factors affect currency rates, except for the difference in inflation and interest rates. These include press releases and economic reports, asset markets, political developments, and the balance of power. Until the 90s, there was little practical evidence of the effectiveness of the theory of equal purchasing power.

The purchasing power parity theory should be used only in fundamental long-term analysis. In the end, economic forces will balance the purchasing power of currencies, but this can take many years. The time horizon is usually five to ten years.

Purchasing Power Parity Theory and its Role in International Business

Applying purchasing power parity as a conversion factor significantly changes the geo-economic picture of the world, bringing developed and developing countries closer together and increasing their share in global GDP.

The reasons for narrowing the gap in GDP between developed and developing countries when using purchasing power parity can be explained, inter alia, by the fact that it eliminates price differences that occur for certain groups of goods and services and is a statistical fact. Thus, compared to estimates based on nominal exchange rates, purchasing power parities tend to significantly increase the GDP of low- and middle-income countries, while at the same time slightly reducing the value of this indicator for high-income countries. For developing countries, therefore, the use of purchasing power parities is particularly important in helping to obtain a more realistic picture of their share of world GDP and in any economic comparison between the two groups of countries.

Nevertheless, despite the existing difficulties, and taking into account that GDP remains an integral indicator of the system of national accounts, comparing the values of this indicator for different countries and regions, calculated based on purchasing power parity of currencies (rather than at the exchange rate), allows getting a more adequate idea about their economic size, economic potential, and power.

Summary: What is PPP?

Wrapping up, we should say that purchasing power parity is an economic term that refers to the ratio of two currencies based on the prices of similar goods in two different countries. For this economic theory to be applied in practice, several conditions have to be met. First, the cost of moving goods from one country to another should be minimal. Second, currencies should be freely convertible. Thus, given the fact that ideal conditions for trade are rare, the calculation of the exchange rate at purchasing power parity is rather theoretical and speaks only about the general orientation, the direction of change in quotes in the distant future.

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