Chapter 17 – Purchasing Power Parity
A paper submitted to Webber International University in partial fulfillment of the requirements for the bachelors of Science degree in Finance.
By: Fabricio dos Santos, Ruta Skinulyte and Leticia Tomb
Professor: Ms. Eberle
Purchasing power parity is an economic technique used when attempting to determine the relative values of two currencies. It is helpful because many times the amount of goods a currency can buy in two nations varies drastically depending upon the availability of products, the demand for goods, and a host of others, it is difficult to determine the factors. Sometimes referred to as the law of one price, PPP implies that the levels of exchange rates and prices adjust so as to cause identical goods to cost the same amount in different countries. For instance, if a pair of tennis shoes costs R$ 150.00 in Brazil and US 100.00 in the United States, then PPP implies that the exchange rate must be R$1.50 per U.S dollar. Consumers could purchase the shoes in the U.S for U$ 100.00, or they could exchange their U$ 100.00 for R$ 150.00 and then purchase the same shoes in the United States at the same effective cost (assuming no transaction or transportation costs). “The question of how exchange rates adjust is central to exchange rate policy, since countries with ﬁxed exchange rates need to know what the equilibrium exchange rate is likely to be and countries with variable exchange rates would like to know what level and variation in real and nominal exchange rates they should expect. In broader terms, the question of whether exchange rates adjust toward a level established by purchasing power parity helps to determine the extent to which the international macroeconomic system is self-equilibrating” (Alan Taylor, 2004)
Purchasing power parity (PPP) implies that the same product will sell for the same price in every country after adjusting for current exchange rates. One problem when testing to see if PPP holds is that it assumes that goods consumed in different countries are of the same quality. For example, if you find that a product is more expensive in Finland than it is in Bolivia, one explanation is that PPP fails to hold, but another explanation is that the product sold in Finland is of a higher quality and therefore deserves a higher price. One way to test for PPP is to find goods that have the same quality worldwide. With this in mind, The Economist magazine occasionally compares the prices of a well-known good whose quality is the same in nearly 120 different countries: the McDonald’s Big Mac hamburger. The Big Mac Index
The Big Mac index of The Economist Magazine believes that the sandwich is a standardized basket of locally produced goods, since, worldwide, it basically uses meat, lettuce, cheese, onions and bread. As we know, it is impossible to trade it between countries, because it is perishable. Thus, there would not be any trades between countries in case of difference in price. If the product is standardized in all countries, so their cost of production should be the same, and thus the price differential would be given by valuation / devaluation exchange rate. The base of the Big Mac Index is a price comparison of the sandwich in the U.S. with the price dollar in other countries: if the sandwich costs more in one country than in the United States, then the local currency is overvalued. When it costs less, the local currency is undervalued.
In the chart above, we can see that the U.S dollar is overvalued against most of the currencies in the world. U.S costumers are one of the most consumers in the world. Foreigners companies and governments try to keep their respective currency as low as they can be to compete in the market against U.S companies. A simple example is China currency and its “currency flotation”. The evidence above suggests that strict PPP does not hold, but the Big...
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