November 23, 2010Exchange Rate

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Purchasing Power Parity (PPP) is the economic theory that continuously adjusts exchange rates between countries in order to denote the purchasing power of each currency. Thus, PPP refers to the basket of basic goods that can be bought with the currency of a given country. This theory is based on the 'law of one price', which states that the same product(s)should be priced identically in different markets. Hence, a country witnessing inflation requires a devaluation of its currencyin the foreign exchange market, so as to equalize the PPP. Moreover, PPP is known to influence only the long-term exchange rates between countries.

## Relative PPP

PPP helps in identifying the relative values of two currencies. The purchasing power of currencies varies depending on factors such as inflation, cost of living and the demand and supply of goods. One such PPP exchange rate that can efficiently compare living standards is the Geary-Khamis dollar or the international dollar.

The formula for calculating relative PPP is:

where,

t = time period

St = spot rate in foreign/domestic currency

Pt = price level in period t

* represents foreign values

This is one of the determinants of absolute purchasing power parity.

Measuring PPP is a difficult task, given the incomparability of the basket of goods across nations. This is because price differences for certain goods may be greater; the type, quality and quantity of goods in the basket may be different and comparing the data of more than two countries is statistically difficult.

One of the efficient tools for calculating PPP is the Big Mac Index. This technique involves comparing McDonald’s Big Mac burger prices across different nations in order to calculate the PPP exchange rates.

The second technique, the iPod Index, calculates the PPP exchange rates by comparing the manufacturing cost of iPods in various countries.

## PPP and Market Exchange Rates

The purchasing power parity of a currency differs from the actual market exchange rates. That is, a currency is either overvalued or undervalued relative to the US or Canadian dollar. For instance, the Danish krone, the Japanese yen and the Swiss franc are overvalued against the US and Canadian dollar. On the other hand, the Mexican peso, the Turkish lira and the Korean won are grossly undervalued.

PPP cannot effectively determine factors such as the actual currency exchange rates, the GDP and the living standards of a country. This ineffectiveness can be attributed to the continuous effects of inflation, the value of goods and several other microeconomic issues.