What is 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. When a country's domestic price level is
increasing (i.e., a country experiences inflation), that country's
exchange rate must depreciated in order to return to PPP.
The basis for PPP is the "law of one price". In the absence of
transportation and other transaction costs, competitive markets
will equalize the price of an identical good in two countries when
the prices are expressed in the same currency. For example, a
particular TV set that sells for 750 Canadian Dollars [CAD] in
Vancouver should cost 500 US Dollars [USD] in Seattle when the
exchange rate between Canada and the US is 1.50 CAD/USD. If the
price of the TV in Vancouver was only 700 CAD, consumers in
Seattle would prefer buying the TV set in Vancouver. If this
process (called "arbitrage") is carried out at a large scale, the
US consumers buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods more costly to
them. This process continues until the goods have again the same
price. There are three caveats with this law of one price. (1) As
mentioned above, transportation costs, barriers to trade, and
other transaction costs, can be significant. (2) There must be
competitive markets for the goods and services in both
countries. (3) The law of one price only applies to tradeable
goods; immobile goods such as houses, and many services that are
local, are of course not traded between countries.
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 Canada and the
United States ECAD/USD is equal to the price level in
Canada PCAN divided by the price level in the United
States PUSA. Assume that the price level ratio
PCAD/PUSD implies a PPP exchange rate of 1.3
CAD per 1 USD. If today's exchange rate ECAD/USD is 1.5
CAD per 1 USD, PPP theory implies that the CAD will appreciate
(get stronger) against the USD, and the USD will in turn
depreciate (get weaker) against the CAD.
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.
Does PPP determine exchange rates in the short term?
No. Exchange rate movements in the short term are news-driven.
Announcements about interest rate changes, changes in perception
of the growth path of economies and the like are all factors that
drive exchange rates in the short run. PPP, by comparison,
describes the long run behaviour of exchange rates. The economic
forces behind PPP will eventually equalize the purchasing power of
currencies. This can take many years, however. A time horizon of
4-10 years would be typical.
How is PPP calculated?
The simplest way to calculate purchasing power parity between two
countries is to compare the price of a "standard" good that is in
fact identical across countries. Every year The Economist
magazine publishes a light-hearted version of PPP: its "Hamburger
Index" that compares the price of a McDonald's hamburger around
the world. More sophisticated versions of PPP look at a large
number of goods and services. One of the key problems is that
people in different countries consumer very different sets of
goods and services, making it difficult to compare the purchasing
power between countries.
According to PPP, by how much are currencies overvalued or undervalued?
The following two charts compare the PPP of a currency
with its actual exchange rate relative to the US Dollar and relative
to the Canadian Dollar, respectively. The charts are updated periodically to
reflect the current exchange rate. It is also updated once
a year to reflect new estimates of PPP. The PPP estimates are
taken from studies carried out by the Organization
of Economic Cooperation and Development (OECD) and others; however,
they should not be taken as "definitive". Different methods of
calculation will arrive at different PPP rates.
The currencies listed below are compared to the US
Dollar. A green bar indicated that the local currency is overvalued by
the percentage figure shown on the axis; the currency is thus expected
to depreciate against the US Dollar in the long run. A red bar
indicates undervaluation of the local currency; the currency is thus
expected to appreciate against the US Dollar in the long run.
Where can I get more information?
National Accounts: The OECD publishes PPPs for all OECD
countries. You can retrieve the PDF file with the 2004 PPP rates from this site.
Also available is a table with the OECD's 1970-2004 PPP rates (also
available as an Excel
file). This is a comma-seprated file that can be easily
imported into a spreadsheet program.
• From The Economist magazine: The Big Mac Index - as they put it "The world's most accurate financial indicator (to be based on a fast food item), with a ten-year retrospective on burgernomics"
• Wilfred J. Ethier: Modern International Economics, 3rd edition.
W. W. Norton & Comp., New York/London: 1995.
Chapter 18, section 2 on "Price Linkages" contains
an excellent non-technical overview of PPP
• Kenneth Rogoff: The Purchasing Power Parity Puzzle,
Journal of Economic Literature, 34(2), June 1996, pages 647-668.
This recent survey provides an overview of developments
with respect to research on PPP, including the
emerging consensus that deviations from PPP do damp out but only
very slowly, at roughly fifteen percent per year. It remains
difficult to explain why the estimated speed of convergence
to PPP is so slow.
• For the more technically minded, I recommend searching the
database for recent research papers on PPP. This is a very active
branch of economic research, both theoretically and empirically.