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

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 to 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?

(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 PPPs 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. When it comes to 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 PPP
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 PPP 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 PPP 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 PPP 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. PPP exchange rates
give China and India far greater weights 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 PPP exchange rates, the per capita income gap between
the richest and poorest countries narrow 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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