Product Research and Reviews

Purchasing Power Parity: Determinants of Currency Exchange Rates Part-II

Suppose a man climbs five feet up a sea wall, then climbs down 12 feet. Whether he drowns or not depends upon how high above sea level he was when he started. The same problem arises in deciding whether currencies are under-or over-valued”. (The Economist, 29 August 1995, p. 70) 

What is purchasing power parity?

Purchasing Power Parity is the rate at which one country’s currency must be converted into another country’s currency in order to purchase the same amount of goods and services in both countries. The law of one price simply states that if two goods are identical, they must sell for the same price in the domestic economy. Previously, we have already discussed Interest Rate Parity theory.

How do I calculate purchasing power parity?

The Big Mac is a hamburger sold by McDonald‘s, an international fast-food restaurant chain. It was first introduced in the Pittsburgh area in 1967, and then nationwide in 1968. It is one of the company’s signature dishes and one of its flagship products. The Economist created the big mac index in 1986 as a lighthearted (joyfully and hopefully optimistic) guide to whether currencies are at their “correct” level. It is based on the purchasing-power-parity (PPP) theory, which states that in the long run, exchange rates should move towards the rate that equalizes the prices of an identical basket of goods and services (in this case, a burger) in any two countries.

The Big Mac PPP

The Big Mac Purchasing Power Parity (PPP) is calculated by dividing the price of a Big Mac in one country’s home currency by the price of a Big Mac in the second country, which is usually the United States. Assume we’re looking at the Big Mac in China. If a Chinese Big Mac costs 10.41 renminbi (RMB) and a US Big Mac costs $2.90, the PPP exchange rate should be 3.59 RMB for US$1 (10.41/2.90). However, if the RMB was trading in the currency market at 8.27 RMB for US$1, the Big Mac PPP would indicate that the RMB is undervalued.

How can we account for the fact that the price of salt has increased by 100 percent and the price of gasoline has increased by 3 percent while everything else has remained constant? One solution would be to take a simple (unweighted) average of the price increases, i.e., (100% + 3%) / 2 = 51.5%. Or more accurately, in recognition of the fact that, aside from salt and gasoline, the price of everything else has remained constant, therefore, (100% + 3% +0%)/3 = 34.33%.

In general, the calculations are deceptive because they implicitly assume that all products, or product categories, are equally important. However, they are not all equally important for most purposes, especially when we are trying to answer a question like: how much of an increase in my salary, pension, or student grant do I need to compensate for this latest round of price increases?

Economists (and, increasingly, governments) address this issue by weighting price increases for individual products by a fraction equal to their proportionate contribution to the average household’s total expenditure. Apart from compiling a retail price index, most governments in industrialized countries now find that they need to collect information on how households spend their income for a variety of reasons.

Assume weights of 0.1 percent for salt and 5.0 percent for gasoline are discovered (which are roughly the correct figures for the UK). The calculation is then as follows: (0.001 100%) + (0.050 3%) = 0.1 percent + 0.15 percent = 0.25 percent

The World Bank (ICP)

According to the World Bank methodology, purchasing power parity (PPP) can be used to convert national accounts data, such as GDP and its expenditure components, into a common currency while also accounting for price level differences between countries. They can also be used to calculate price level indexes (PLIs), which are the ratios of a country’s Purchasing Power Parity (PPP) to its market exchange rate and can be used to compare prices across countries. PPPs and the PLIs and real (or PPP-adjusted) expenditures that they generate have a wide range of applications, but they are particularly useful for empirical work involving comparisons of per capita consumption or levels of GDP (or other GDP aggregates) across countries, as well as for measuring global poverty and income inequality.

The International Comparisons Program (ICP) was established in 1968, is one of the world’s largest statistical initiatives. It is managed by the World Bank under the auspices of the United Nations Statistical Commission, and it is based on a collaboration of international, regional, sub-regional, and national organizations that work within a strong governance framework and adhere to a well-established statistical methodology.

The ICP’s main goals are to: (i) produce purchasing power parities (PPPs) and comparable price level indexes (PLIs) for participating economies; and (ii) use PPPs to convert volume and per capita measures of GDP and its expenditure components into a common currency.

Because of the breadth and depth of ICP data, its use-cases can extend beyond economics, such as empirical analyses of economic growth, productivity, and trade, and even beyond, to help track global targets such as the UN Sustainable Development Goals for health, education, energy and emissions, and labor. Other uses for ICP data include the creation of indexes, such as cost-of-living measures. Given the increased importance of cross-country benchmarking, among other possibilities, use-cases can even be extended into the policymaking domain at all levels (global, regional, and national). PPPs should be used for the following purposes: making spatial comparisons of GDP and its expenditure components; making spatial comparisons of price levels.

To categorize countries based on their per capita volume and price indexes. PPPs with limitations is recommended for the following purposes: analyzing changes over time in relative GDP per capita and relative prices; analyzing price convergence; making spatial comparisons of the cost of living; using purchasing power parity calculated for GDP and its expenditure components as deflators for other values.

The best way to aggregate economic data across countries depends on the issue at hand. Regarding financial flows, market exchange rates are the obvious choice. The current account balance, for example, which measures funds coming into and out of a country, represents a flow of financial resources across borders. When aggregating across regions or calculating the global current account deficit, it is appropriate to use the market exchange rate to convert these flows into dollars.

However, the decision for other variables is more ambiguous. The World Bank determines the weights in its regional and global aggregations of real GDP using market-based rates, whereas the IMF and the Organization for Economic Cooperation and Development use purchasing power parity rates (although the IMF also publishes a global growth aggregate based on market rates in the WEO).

One of the primary benefits of purchasing power parity (PPP) is that exchange rates are relatively stable over time. Market rates, on the other hand, are more volatile, and using them can result in large swings in aggregate measures of growth even when growth rates in individual countries are stable. Another disadvantage of market-based rates is that they are only applicable to internationally traded goods.

A haircut in New York costs more than one in Karachi; a taxi ride of the same distance costs more in Paris than in Tunis, and a ticket to a cricket match costs more in London than in Lahore. Indeed, because wages in poorer countries tend to be lower and services are often labor-intensive, the price of a haircut in Karachi is likely to be lower than in New York, even if the cost of producing tradable goods, such as machinery, is the same in both countries. Any analysis that fails to account for these price differences in nontraded goods across countries will understate the purchasing power of consumers in emerging markets and developing countries, and thus their overall welfare.

One of the most significant disadvantages of purchasing power parity is that it is more difficult to measure than market-based rates. The ICP is a massive statistical project, and new price comparisons are only available at irregular intervals. Earlier surveys have also raised methodological concerns. PPP rates must be estimated between survey dates, which can introduce inaccuracies in the measurement. Furthermore, because the ICP does not cover all countries, data for missing countries must be estimated.

In terms of the difference between market- and PPP-based rates, there is a significant difference between market- and PPP-based rates in emerging market and developing countries, with the majority of them having a market-to-PPP U.S. dollar exchange rate ratio of 2 to 4. However, in advanced economies, the market and purchasing power parity rates are much closer. As a result, developing countries receive far more weight in aggregations based on PPP exchange rates than they do in aggregations based on market exchange rates. Purchasing power parity exchange rates give China and India far greater weight in the global economy than market-based weights.

Thus, the choice of weights has a large impact on global growth calculations but has little impact on estimates of aggregate growth in advanced economies. Under Purchasing Power Parity exchange rates, the per capita income gap between the richest and poorest countries narrows slightly (though it remains exceptionally large), and some countries move up or down the income scale depending on the exchange rate conversion used.

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