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. 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. Therefore when a country's domestic price level is increasing, that is a country experiences inflation, if PPP holds then it follows that country's exchange rate must depreciate in order to return to equilibrium.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalise the price of an identical good in two countries when the prices are expressed in the same currency. Otherwise there is an arbitrage opportunity (arbitrage being defined as “the simultaneous purchase and sale of substantially identical assets in order to profit from a price difference between the two assets” Wall Street Words: An Essential A to Z Guide for Today's Investor by David L. Scott, © 1997, 1998 by Houghton Mifflin Company).
If arbitrage is carried out at a large scale, the consumers buying foreign goods will bid up the value of the foreign currency, thus making those goods more costly to them. This process continues until the foreign goods and the domestic goods have the same price. There are three caveats with this law of one price:
•Transportation costs, barriers to trade, and other transaction costs, can be significant. •There must be competitive markets for the goods and services in both countries. •The law of one price only applies to tradable goods and does not apply to immobile goods such as houses, and many services that are local such as haircuts.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate between the UK and France is equal to the price level in the UK divided by the price level in France. Assume that the price level ratio implies a PPP exchange rate of 9 FF per 1 GBP. If today's exchange rate is 10.5 FF per 1 GBP, PPP theory implies that the FF will appreciate against the GBP, and the GBP will in turn depreciate against the FF.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. 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. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large.
The Big Mac Index
In practice, identical products often sell at different prices, adjusted for exchange rates, in different countries. The Economist’s “Big Mac Index” is based on this point. It is a calculation of “real” exchange rates, which measure the relative costs of goods—not currencies. A Big Mac in, say, London costs a certain number of pounds sterling, and a Big Mac in, say, Paris costs a certain number of pounds when converted from French Francs or Euros. Using PPP theory, the pound cost of both ought to be the same: the real exchange rate should be one Big Mac in London for one Big Mac in Paris. In practice the two prices are almost always different....