Purchasing power parity
Purchasing power parity (PPP) is a measure of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of countries' currencies. In many cases, PPP produces an inflation rate that is equal to the price of the basket of goods in one location divided by the price of the basket of goods in a different location. Inflation and the PPP exchange rate may differ from the market exchange rate due to poverty, tariffs, and other transaction costs. The concept of purchasing power parity originated in the School of Salamanca in the 16th century, and was developed in its modern form by Gustav Cassel in 1916.
Concept
Purchasing power parity is the economic term for the measurement of prices in different places. It is based on the law of one price, which says that if there are no transaction costs or trade barriers for a particular good, the price of that good should be the same everywhere. Ideally, a computer or salary average have the same price in New York and Hong Kong. If its price is US$500 in New York and the same computer or salary is worth HK$2,000 in Hong Kong, then PPP theory says that the exchange rate should be HK$4 to US$1.
Poverty, tariffs, transportation, and other frictions impede the trade and acquisition of diverse goods, so measuring a single good can lead to great error. PPP does this by using a basket of goods, that is, many goods in different amounts. PPP then calculates an inflation rate and an exchange rate as the ratio of the basket price in one location to the basket price in another. For example, if the price of a basket consisting of 1 computer, 1 ton of rice, and 1 ton of steel is US$1,800 in New York and the same goods cost HK$10,800 in Hong Kong, the PPP exchange rate would be HK$6 for every US$1.
The name purchasing power parity comes from the idea that, with the right exchange rate, consumers in each place will have the same purchasing power.
The value of the PPP exchange rate depends to a large extent on the chosen basket of goods. In general, goods are chosen that could closely obey the law of one price. Therefore, the ones that are easily traded and commonly available in both places. Organizations that calculate PPP exchange rates use different baskets of goods and may arrive at different values.
The PPP exchange rate may not match the market exchange rate. The market rate is more volatile because it reacts to changes in demand at each location. In addition, tariffs and the difference in the price of labor (see the Balassa-Samuelson theorem) can contribute to the longer-run differences between the two types. One use of PPP is to predict longer-term exchange rates.
Because PPP exchange rates are more stable and less affected by tariffs, they are used for many international comparisons, such as comparing countries' GDPs or other national income statistics. These numbers are often labeled PPP-adjusted.
There can be marked differences between income adjusted for purchasing power and income converted via market exchange rates. A well-known purchasing power adjustment is the Geary-Khamis dollar (the international dollar). The World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to approximately 1.8 Chinese yuan per purchasing power parity significantly different from the nominal exchange rate. This discrepancy has big implications; for example, when converted through nominal exchange rates, nominal GDP per capita in India is about US$1,965, while on a PPP basis it is about US$7,197. In the other extreme, for example, Denmark's nominal GDP per capita is around $53,242, but its PPP figure is $46,602, in line with other developed nations.
Variations
There are variations in the dpi calculation. The EKS method (developed by Ö. Éltető, P. Köves and B. Szulc) uses the geometric mean of exchange rates calculated for individual goods. The EKS-S method (by Éltető, Köves, Szulc and Sergeev) uses two different baskets, one for each country, and then average the result. While these methods work for 2 countries, the exchange rates can be inconsistent if applied to 3 countries, so additional adjustment may be needed to make the rate from currency A to B times the rate from B to C be equal to the rate from A to C.
Use
Conversion
The purchasing power parity exchange rate is used when comparing domestic production and consumption and other places where the prices of non-traded goods are considered important. (Market exchange rates are used for the individual goods being traded.) PPP rates are more stable over time and can be used when that attribute is important.
PPP exchange rates help costs, but exclude benefits and, above all, do not take into account the different quality of products between countries. The same product, for example, may have a different level of quality and even safety in different countries, and may be subject to different taxes and transport costs. Since market exchange rates fluctuate substantially, when a country's GDP measured in its own currency is converted to the other country's currency using market exchange rates, it can be inferred that a country has a higher real GDP. than the other country in one year but lower in the other; both inferences would not reflect the reality of their relative levels of production. But if one country's GDP is converted to the other country's currency using PPP exchange rates instead of observed market exchange rates, the false inference will not occur. Essentially, GDP is measured with PPP controls for different costs of living and price levels, usually relative to the United States dollar, allowing for a more accurate estimate of a nation's level of production..
The exchange rate reflects the transaction values of goods traded between countries in contrast to non-traded goods, that is, goods produced for use in the country of origin. In addition, currencies are traded for purposes other than trade in goods and services, for example, to purchase capital goods whose prices vary more than those of physical goods. In addition, different interest rates, speculation, hedging or central bank interventions can influence the foreign exchange market.
The PPP method is used as an alternative to correct possible statistical biases. The Penn World Table is a widely cited source of PPP adjustments, and the associated Penn effect reflects a systematic bias in the use of exchange rates to products between countries.
For example, if the value of the Mexican peso falls in half compared to the US dollar, Mexico's gross domestic product measured in dollars will also halve. However, this exchange rate is the result of international trade and financial markets. It does not necessarily mean that Mexicans are poorer in half; if income and prices measured in pesos remain the same, they will not be worse off assuming that imported goods are not essential to people's quality of life. Measuring income in different countries using PPP exchange rates helps to avoid this problem, as the metrics imply relative wealth with respect to local goods and services in national markets. On the other hand, it is deficient in measuring the relative cost of goods and services in international markets. The reason is that it does not take into account how much 1 USD represents in a respective country. Using the example mentioned above: in an international market Mexicans can buy less than Americans after their currency crash, even though their GDP PPP changed a bit.
Exchange Rate Forecast
PPP exchange rates are never valued because market exchange rates tend to move in their general direction, over a period of years. There is some value in knowing which direction the exchange rate is most likely to move in the long run.
In neoclassical economic theory, purchasing power parity theory assumes that the exchange rate between two currencies actually observed in the foreign exchange market is the one used in purchasing power parity comparisons, so that the same amount of goods could be purchased in either currency with the same initial amount of funds. Depending on the particular theory, purchasing power parity is assumed to hold in the long run or, more strongly, in the short run. Purchasing power parity theories assume that in some circumstances a drop in the purchasing power of either currency (an increase in its price level) would lead to a commensurate decline in that currency's valuation on the currency market. foreign exchange.
Identification of manipulation
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes apply official exchange rates that make their own currency artificially strong.[citation needed] In contrast, the rate Black market exchange for currency is artificially weak. In such cases, a PPP exchange rate is probably the most realistic basis for economic comparison. Similarly, when exchange rates deviate significantly from their long-term equilibrium due to speculative attacks or carry trades, a PPP exchange rate offers a better alternative for comparison.
Problems
The calculation of the PPP exchange rate is controversial due to the difficulties of finding comparable baskets of goods to compare purchasing power across countries.
Estimating purchasing power parity is complicated by the fact that countries do not simply differ on a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also being less than the difference in entertainment prices. People in different countries tend to consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to buy differ from country to country.
Therefore, adjustments need to be made to account for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat more bread; Chinese plus rice. Therefore, a PPP calculated using US consumption as a base will differ from one calculated using China as a base. Multilateral comparisons pose additional statistical difficulties when (as is often the case) more than two countries are compared.
Various ways of averaging bilateral PPPs can provide a more stable multilateral comparison, but at the cost of distorting the bilateral ones. These are all general indexing issues; As with other price indices, there is no way to reduce the complexity to a single number that is equally satisfactory for all purposes. However, PPPs are often robust against the many problems that arise from using market exchange rates for comparisons.
For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was US$0.91, and in Norway the price was US$6.27. Significant price differences would not contribute to the precision in a PPP analysis, despite all the variables that contribute to the significant differences in price. More comparisons must be made and used as variables in the general formulation of the PPP.
When PPP comparisons are to be made over some time interval, it is necessary to take due account of inflationary effects.
In addition to the methodological issues raised by selecting a basket of products, PPP estimates may also vary depending on the statistical power of participating countries. The International Comparison Program, on which the PPP estimates are based, requires the disaggregation of national accounts into output, expenditure, or (in some cases) income, and not all participating countries routinely break down their data into these categories.
Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for the comparison between the Ethiopian worker living on teff and the Thai worker living on rice, because teff is not commercially available in Thailand and rice is not in Ethiopia, so one cannot determine the price of rice in Ethiopia or teff in Thailand. As a general rule, the more similar the price structure across countries, the more valid the PPP comparison.
The PPP levels will also vary depending on the formula used to calculate the price matrices. Possible formulas include GEKS-Fisher, Geary-Khamis, BID, and the superlative method. Each has advantages and disadvantages.
Linking regions presents another methodological difficulty. In the 2005 round of PCI, regions were compared using a list of about 1,000 identical items that could be priced for 18 countries, selected so that at least two countries were in each region. While this was superior to the "bridge" The above, which do not fully take into account the different quality between goods, may serve to overstate the PPP base of the poorest countries, because the price indexation on which the PPP is based will assign to the poorest countries the highest weight of goods consumed in greater proportion in the richest countries.
There are a number of reasons why different measures do not perfectly reflect living standards.
Range and quality of products
The goods that the currency has the “power” to buy are a basket of goods of different types:
- Non-transferable local goods and services (such as electricity) that are produced and sold in the country.
- Commercialable goods such as non-perishable products that can be sold on the international market (such as diamonds).
The further a product falls into category 1, the further its price will be from the currency exchange rate, moving towards the PPP exchange rate. By contrast, category 2 products tend to trade close to the currency exchange rate.
Products that are more processed and expensive are likely to be tradable, falling into the second category and deviating from the PPP to the currency exchange rate. Even if the "value" of the Ethiopian PPP currency is three times as strong as the currency's exchange rate, you won't buy three times as much internationally traded goods like steel, cars, and microchips, but non-traded goods like homes, services («haircuts») and nationally produced crops. The relative price difference between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect and gives a large cost advantage to the labor-intensive production of tradables. in low-income countries (such as Ethiopia), compared to high-income countries (such as Switzerland).
The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the wages of those workers go further in low-income countries than in high-income ones, relative wage differentials (between countries) may be sustained for longer than would otherwise be the case. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be obtained locally (closer to the PPP exchange rate than the nominal exchange rate at which receipts are paid). These act as a cheaper factor of production than the one that the factories of the richest countries have. It is difficult because of GDP PPP to consider the different quality of goods between countries.
The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the Balassa-Samuelson theory. This view asserts that price levels of non-tradables are lower in poorer countries because of differences in labor and capital endowments, not because of lower levels of productivity. Poor countries have more labor relative to capital, so the marginal productivity of labor is higher in rich countries than in poor countries. The non-tradeable tend to be labor intensive; therefore, because labor is less expensive in poor countries and is used mainly for non-tradables, non-tradables are cheaper in poor countries. Wages are high in rich countries, so non-tradeables are relatively more expensive.
PPP calculations tend to overemphasize the primary sectoral contribution and downplay the sectoral contributions of industry and services to a nation's economy.
Trade and non-trade barriers
The law of one price, the underlying mechanism behind PPPs, is weakened by transportation costs and government trade restrictions, which make it more expensive to move goods between markets located in different countries. Transportation costs break the link between exchange rates and the prices of commodities implicit in the law of one price. As transportation costs increase, the greater the range of fluctuations in exchange rates. The same can be said for official trade restrictions because customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "any kind of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country." They cite the example that a dollar in London should buy the same goods as a dollar in Chicago, which is certainly not the case.
The non-tradeables are mainly the services and the production of the construction industry. Non-tradables also lead to deviations in PPP because the prices of non-tradables are not linked internationally. Prices are determined by domestic supply and demand, and changes in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of non-tradeables rise, the purchasing power of any given currency will fall in that country.
Exits from free competition
The links between national price levels are also weakened when trade barriers and imperfectly competitive market structures co-occur. Market pricing occurs when a company sells the same product at different prices in different markets. This is a reflection of the differences between countries in conditions both on the demand side (for example, there is practically no demand for pork in the Islamic states) and on the supply side (for example, if the market supplier for a potential entrant's product has few suppliers or is already nearly saturated). According to Krugman and Obstfeld, this emergence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Over time, changes in the market structure and demand will occur, which may invalidate the relative PPP.
Differences in price level measurement
The measurement of price levels differs from country to country. Inflation data for different countries are based on different baskets of commodities; therefore, changes in exchange rates do not compensate for official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, the change in the relative prices of the basket components may cause the relative PPP not to fail the tests that are based on the official price indices.
Global Poverty Line
The global poverty line is a worldwide count of people living below an international poverty line, known as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the world line is converted back to local currency using PCI PPP exchange rates. PPP exchange rates include data on sales of non-poverty high-end items, which skews the value of food and necessities, which is 70 percent of consumption by the poor. Angus Deaton argues that PPP indices should be reweighted for use in measuring poverty; they should be redefined to reflect local measures of poverty, not global measures, weigh local foods, and exclude luxury items that are infrequent or do not have the same value in all locations.
History
The idea originated with the School of Salamanca in the 16th century, and was developed in its modern form by Gustav Cassel in 1916, in The Present Situation of Foreign Trade. While Gustav Cassel's use of the PPP concept has traditionally been interpreted as his attempt to formulate a positive theory of exchange rate determination The political, and theoretical context in which Cassel wrote about exchange rates suggests a different interpretation. In the years immediately before and after the end of World War I, economists and politicians engaged in discussions about possible ways to restore the gold standard, which would automatically restore the system of fixed exchange rates between participating nations. The stability of exchange rates was generally considered crucial to restore international trade and to keep its growth stable and balanced. No one was then mentally prepared for the idea that flexible exchange rates determined by market forces do not necessarily cause chaos and instability in peacetime (and that is what the abandonment of the gold standard during the war was blamed for).. Gustav Cassel was one of those who supported the idea of restoring the gold standard, albeit with some alterations. The question, which Gustav Cassel tried to answer in his works written during that period, was not how exchange rates are determined on the free market, but rather how to determine the appropriate level at which exchange rates should be fixed during the restoration of the system of fixed exchange rates. His recommendation was to set exchange rates at the PPP level, as he believed this would prevent trade imbalances between trading nations. Thus, the PPP doctrine proposed by Cassel was not really a positive (descriptive) theory of exchange rate determination (since Cassel was well aware of numerous factors that prevent exchange rates from stabilizing at the exchange rate level). PPP if allowed to float), but rather normative (prescriptive) policy advice, formulated in the context of discussions about a return to the gold standard.
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