Purchasing Power Parity
March 23, 2009
Purchasing Power Parity
It is a theory that tends to estimate the ratio and extend of adjustment to be done on the exchange rate among countries so that the exchange can be equal to each country’s currency purchasing power. It is a technique that is used to simply determine the relative value of two varied currencies. Purchasing power parity is of great importance and useful because normally the amount of goods a currency can purchase varies greatly in two different countries.
The variable is caused mainly by the supply and demand of the goods, among many other factors. What PPP does is simply take an international measure and determine the cost for that measure in either of the two currencies, and then compare the amount. As a result, the exchange rate adjusts so that a particular good in two trading nations has an equal price when expressed in an identical currency.
Purchasing power parity is based on an economic theory that states that in perfect competent markets, similar goods should have only one price. The theory uses the long-term balance exchange rates of the currencies in question to make equal their purchasing power. Important to note is that purchasing power parity generalizes the price of items in broad classes and does not take into account specific characters such as quality of the items or goods.
Importance of Purchasing Power Parity
PPP comes into play when comparing the living standards and poverty level of two different nations. This is because it takes into account the inflation rate and the relative cost of living, instead of simply using only the ostensible GDP or Gross Domestic Product comparison.
Equally, purchasing power parity is used to lessen the deceptive effects of shifts in a nation’s currency. This is because PPP looks at the value of lump some goods and not just one or two; the exchange rate will be determined and will vary depending on the index of the items. This problem of misleading effects tends to happen mostly when the Gross Domestic Product is being calculated.
Still on point, the exchange rates created by PPP are important in countries where official exchange rates are falsely manipulated by governments, to make their currencies appear artificially strong. This applies in nations where the government has a strong control of the economy. Contrariwise, the black market exchange rate of such countries is artificially weak. The purchasing power parity exchange rate thus becomes the most realistic foundation for economic comparison.
PPP difficulties
It is difficult to reflect the perfect living standard of a nation using PPP numbers because they can vary with particular baskets of goods used. Equally, the quality of goods is roughly estimated in PPP. Purchasing power parity tends to under-emphasize the service and industrial sectoral contributions and over-emphasize the primary sectoral contributions to a nation’s economy.
By the same token, purchasing power parity exchange rates can be used to compare income and living standards in different nations, and is much better than market exchange rates. However, the method can still be misleading. This is so because when comparing living standards using PPP method, it unreservedly means that the real value of the goods is equal on all nations. This isn’t true. Whereas a certain country may consider a particular good a necessity, another country may perceive the same good as a luxury.
Purchasing power parity may have complexities in accounting for differences in the quality between goods in a country and equivalent goods in another. By and large, the consumer price index (CPI) hugely determines the PPP exchange rate, thus it is very likely to accidentally or purposely base a purchasing power parity exchange rate by preference of bundle.
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