Purchasing power parity (PPP) is an economic theory that states that the exchange rate between two countries is equal to the ratio of the prices of a basket of goods in each country. In other words, Purchasing power parity  suggests that the exchange rate between two countries should be equal to the price ratio of a basket of goods in each country.

For example, if the price of a basket of goods in the United States is $100 and the price of the same basket of goods in Japan is ¥10,000, the purchasing power parity exchange rate between the two countries would be ¥100/$. This means that one U.S. dollar should be able to buy the same basket of goods in both the United States and Japan.

Purchasing power parity is often used to compare the purchasing power of different currencies and to determine whether a currency is overvalued or undervalued. It is based on the idea that goods and services should cost the same in different countries when their prices are converted into a common currency.

There are several assumptions underlying the PPP theory, including the assumption that goods and services are freely traded between countries, that there are no transportation costs or tariffs, and that there are no barriers to trade or investment. In practice, these assumptions are not always met, which means that PPP may not always hold true.

Despite its limitations, PPP is widely used as a benchmark for comparing the purchasing power of different currencies and is often used to predict changes in exchange rates. It is also used by international organizations such as the International Monetary Fund (IMF) and the World Bank to compare economic indicators and to assess the economic performance of different countries.

One of the main assumptions of PPP is that goods and services should be relatively cheaper in countries with lower levels of development and higher levels of productivity, as it should be cheaper to produce these goods and services in these countries. This means that, in theory, the exchange rate between two countries should reflect the relative price levels of goods and services in each country.

However, there are many factors that can cause deviations from purchasing power parity  in practice. For example, trade barriers and other protectionist policies can artificially increase the price of goods in one country, leading to deviations from purchasing power parity. Inflation rates can also cause deviations from Purchasing power parity, as an increase in the price level in one country will lead to a depreciation of its currency relative to another country with a lower inflation rate.

Another factor that can affect purchasing power parity is the so-called “Baumol’s cost disease,” which suggests that the cost of certain services, such as healthcare and education, tends to increase faster than the overall price level due to factors such as rising wages and technological progress. This can lead to deviations from PPP, as the price of these services may be relatively higher in some countries compared to others.

Overall, while PPP is a useful theoretical benchmark, it is important to keep in mind that there are many factors that can cause deviations from PPP in practice, and exchange rates often do not reflect PPP in the short-term.

Ways in which purchasing power parity can be measured and used in practice.

1. One common method is to use a basket of goods and services that are representative of the consumption patterns in each country, and compare the prices of this basket in each country. This allows for a more accurate comparison of the cost of living in different countries, as it considers the specific goods and services that are consumed in each country.
2. Another way in which PPP can be used is to compare the gross domestic product (GDP) of different countries at purchasing power parity (PPP) exchange rates. This allows for a comparison of the size of the economy and the standard of living in different countries, considering the relative price levels of goods and services in each country.
3. Purchasing power parity is also used in international finance as a theoretical benchmark for exchange rates. According to the theory of purchasing power parity, exchange rates should adjust over time to reflect the relative price levels of goods and services in different countries. However, in practice, exchange rates often deviate significantly from Purchasing Power Parity due to various economic and political factors.

 

To conclude, purchasing power parity (PPP) is a theory that suggests that exchange rates between countries should be equal to the ratio of the price levels of goods and services in each country. This means that the price of a basket of goods and services should be the same in each country, after adjusting for exchange rate differences.  is often used as a measure of the relative cost of living in different countries, and it can be used to compare the real incomes and living standards of people in different countries. It is also used as a theoretical benchmark for exchange rates, although in practice, exchange rates often deviate significantly from purchasing power parity  due to a variety of factors. There are several methods for measuring and using purchasing power parity in practice, including comparing the prices of a basket of goods and services and comparing Gross Domestic Product  at purchasing power parity exchange rates. However, it is important to keep in mind that there are many factors that can cause deviations from PPP in practice, and exchange rates often do not reflect purchasing power parity in the short-term.

Limitations of purchasing power parity theory

•  It ignores many real determinants: The theory shows a direct link between the purchasing power and exchange rate and ignores many other factors of exports and imports involved behind the operation.

 

•  It is based on unrealistic assumptions: According to Heckscher, “the conception that the exchanges represent relative price levels; or what is the same thing, that the monetary unit of a country has the same purchasing power both within the country and outside, it is correct only upon the never existing assumption that all goods and services can be transferred from one country to another without cost.

 

• In this case, the agreement between the prices of different countries is even greater than that which is covered by the conception of an identical purchasing power of the monetary unit, for not only average price levels but also the price of each particular commodity or service will then be the same in both countries if computed on the basis of the exchange.”

 

•  The purchasing power parity theory is an empty truism: It states that changes in foreign exchange rate must reflect changes in price levels of the countries. But, goods traded internally only have no direct bearing on the exchange value of the currency and their prices may be fluctuating without affecting the exchange rate. “Confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism,” says Keynes.

 

•  The theory overlooks the influence of demand and supply factors in foreign exchange: Nurkse underlines that the theory considers “demand simply as a function of price, leaving out of account the wide shifts in the aggregate income and expenditure which occur in the business cycle and which lead to wide fluctuations in the volume and hence the value of foreign trade even if prices or price relationships remain the same.”

 

•  The theory holds good in the long run: But, what about the short term which really is more significant? Because, “in the long run we are all dead, and after death, there is no economic problem.”

 

•  According to the theory, to calculate the new equilibrium rate, one must know the base rate, i.e. the old equilibrium rate: But it is difficult to ascertain the particular rate which actually prevailed among the currencies as the equilibrium rate. Moreover, the calculated new rate would represent the equilibrium rate at purchasing power parity only if economic conditions have remained unchanged.

 

• It disregards the basis of international trade: The theory assumes that we are dealing with a similar group of commodities in both countries. This assumption is not tenable, when the very base of international trade is geographical specialization in production. Moreover, the concept of a change in the price is vague in theory. Prices of all commodities never move uniformly. Prices of some commodities rise or fall much more than those of others. Under such conditions, no simple comparison can be made between the price movements in different countries.

•        The theory neglects capital transactions in international economic relations:

It fails to take into consideration any item in the balance of payments other than merchandise trade. That is to say, the purchasing power parity theory applies at best only to current account transactions neglecting capital account completely. Kindle Berger states that the purchasing power parity theory is designed for trading nations and gives little guidance to a country which is both a trader and a bank.

 

Thanks for reading this article. Have a fruitful day ,won’t you!!!