Purchasing Power Parity Analysis

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Purchasing Power Parity Analysis
Paul Streeten defying Purchasing Power as: “The amount of goods and services bought by a unit of currency. It is therefore the reciprocal of a price index: when prices go up, purchasing power falls”. In addition, he establishes that Purchasing Power Parity (PPP) is the theory that exchange rates between currencies are determined, in equilibrium or in the long run, by the amount of goods and services that a currency can buy. If £1 in Britain buys what $1.50 buys in the United States, the equilibrium exchange rate would be £1 = $1.50”. The theory was propounded by the Swedish economist Gustav Cassel (1866–1944) in 1916 when a system of free exchange rates prevailed. If the prices of tradable goods are lower in one country than in another, allowing for transport costs and tariffs, people buy these cheaper goods and sell them in the dearer country. In the cheaper country the prices of goods or the value of the exchange rate will rise. But not all goods and services are tradable (e.g., government services), and transport costs, tariffs, capital movements, and government policies interfere with the long-term tendency to equality of the purchasing power of different currencies. One of the foundations of international economics is the theory of Purchasing Power Parity, which states that price levels in any two countries should be identical after converting prices into a common currency. As a theoretical proposition, PPP has long served as the basis for theories of international price determination and the conditions under which international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept. (Pakko & Pollar, 2003). Another version of the theory explains changes in the exchange rate by changes in the relative purchasing power of the currencies. The explanation of the exchange rate is that it depends on supply and demand, and purchasing power is only one of many factors that determine supply and demand. If the Purchasing Power Parity theory were correct, converting incomes per head of different countries at the current exchange rate would yield accurate comparisons of the command over goods and services. But since the purchasing power parity theory does not hold, the real income per head of poor countries is, for example, underestimated when converted by exchange rates. The low relative prices of many non-traded services, such as those of teachers or barbers or retailers, produce for poor countries a substantially higher purchasing power. For purposes of international comparisons indices of relative national price levels that use absolute price comparisons have some advantages. Nevertheless, the theory provides a useful benchmark for policies. Possibly the most well known example of Purchasing Power Parity was given by The Economist Magazine as The Big Mac Index since 1986. Using the Big Mac index, we determine the cost of a Big Mac in a number of countries and are able to conclude an exchange rate based on this index. For instance, if a Big Mac costs $3.41 in the US, and 23.32 Yuan in China, we can determine that the exchange rate is $1 for 6.8398 Yuan. One of the primary uses of Purchasing Power Parity is in lessening the misleading effects of shifts in a national currency. This is particularly an issue when calculating a nation's Gross Domestic Product. For example, if the Yuan falls in value to 80% of its value on the dollar, the GDP as expressed in US dollars will also drop to 80%. This does not accurately reflect the standard of living in that country (a common use of GDP), however, because the devaluation of the riel is most likely due to international trade issues that will not yet have had any effect on the average Chinese. By using purchasing power parity, however, we are not misled by the temporary devaluation of the Yuan in relation to the dollar — a Big Mac still costs 23.32 Yuan in China and $3.41 in the US, and so...
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