Purchasing Power Parity Theory And Discuss Its Applicability Economics Essay

Purchasing Power Parity theory (PPP) is a basis for economic comparison. However, can this really be true for any product at any time? Is purchasing power parity (PPP) only valid in the long run, or is it also applicable in the short run, and what about the nature of the products, i.e. tradable and non-tradable goods? Which limitations are there to PPP?

Purchasing power parity tries to explain why the real exchange rate between currencies is what it is. It is based on the “law of one price” which states that in different markets, identical goods should have the same price. For goods which are easily traded, such as steel and iron, prices should be identical within relevant range. The reason for this is that if £100 could get you 10kg of iron in the domestic UK market, or 5kg in the foreign German market, one would expect people to buy iron in the UK and sell it in Germany for a profit, taken into consideration that shipping costs are negligible, and that the iron is of equivalent quality. Demand for UK iron would rise and demand for German iron would fall. In the long run this would result in prices for domestic UK iron to rise and for foreign German iron to fall. The equilibrium here would be that £100 could buy you 7.5kg of UK iron, or 7.5kg German iron.

As the currency used in the UK and Germany is different we need to know how many British pound we need in order to buy one Euro. If you need £15 to get a haircut in the UK and you need €10,50 to buy the same quantity (one haircut) in Germany, then the real exchange rate would be £1.43 per € found by the formula:

which equals .

This strength/purchasing power of one currency over another should be equal in the long run. Hence the name purchasing power parity. Rogoff argues that the difference between the actual currency exchange rate and the PPP exchange rate is..

PPP is only a theory as it cannot be proven to be correct, but until it is not disproved it is seen as a valid assumption. It is considered to be valid in the long run and not the short run, as people take time to realise and exploit profitable differences in markets which eventually leads to a long run market equilibrium. Michaely (1982) argues that the PPP, which originally came from Gustav Cassel, is “indeed a monetary approach analysis; namely that it assigns the determination of the foreign-exchange rate to the money market alone, without allowing an explanatory role to the goods market and to goods prices.”

As the real exchange rates are affected by tradable goods as well as by services, different interest rates, speculators and investment, it is not the best method to compare the purchasing power of different currencies. Comparing GDP (gross domestic product) can be done if PPP is used to compare currencies on the bases on a basket of goods.

We can differentiate goods and services in a basket of goods into two categories: tradable goods and non tradable/domestic goods. This is decided upon how easily transported/traded a good is as well as government policies such as bans, tariffs and quotas imposed on them. Tradable goods, (commodities) which are of equal quality no matter where they are produced, will be traded at a value close to the market exchange rate. Generally, any good that is easily transported belongs into this category. Highly tradable goods are raw materials such as gold, petrol, gas, oil and diamonds which have a high value. Non tradable goods that are produced and used by domestic consumers such as hairdressers, taxi costs, house rent, and books are hard to get exported, and as foreign people are unlikely to find a hairdresser whose price can compensate the costs of travelling, or move houses just because it is cheaper than the current one, the non tradable goods will be closer to the PPP exchange rate rather than the actual market exchange rate.

Whether a good is tradable or non-tradable does not only depend on how easily it can be transported. Books may be cheap in Germany and are easily transported, yet there is little demand in the UK for German books, as they are written in a different language. The same can be said about packaged food and laptops for certain countries that have different letters in their alphabet. Their PPP may be further away from the real exchange rate, as they would behave like non tradable goods.

There are exceptions to this rule, such as expensive surgeries or medical care which is often much cheaper in east Europe than in west Europe. But are these of equal quality? The difference in price is due to different qualifications, less equipment and less experience. Eventually, in the long run, we would expect prices of east European doctors to rise, but there will still be a large enough price difference which is due to travel and quality difference.

As PPP is based on a basket of goods and services, this already excludes ones that are not recorded. Many of these goods are not tradable, and hence are affected by the income level of these countries. However, there are goods in foreign countries that are purposely priced under international market price, in order to get a market share. For example, the German car manufacture Volkswagen produces cars in Germany and sells them in Poland for less than in Germany. Volkswagen does this because people in Poland earn less than in Germany, and they want to get a large market share. Some of these cars get re-imported into Germany to be sold under the domestic price. As Volkswagen cannot increase its price in Poland without losing customers and market share, car dealers in Germany will need to lower their prices in order to eventually get to equilibrium.

Besides the obvious limitation to PPP that products are not always homogeneous, there is also the problem with “apparent” quality difference. A Product manufactured in England might be seen as of superior quality to the exact same product manufactured in China. Both products, even though they are equal, would have different equilibrium prices.

PPP does not work in the short run, as people take time to take notice of opportunities to exploit differences in prices. It is only valid for highly tradable and valuable goods such as diamonds and gold, as these prices. Antweiler says that short run exchange rate movements are influenced by the news, such as “announcements about interest rate changes, changes in the perception of the growth path of economic”(2009).

Pappell (1997) discusses that the difference between PPP and the real exchange rate can also depend on which country’s currency we base it on. This can happen because of regime changes or because governments are artificially interfering with the exchange rate in order to increase growth. Generally, the lower the income level of an economy is, the further away the PPP is from the real exchange rate, and the more an economy develops, the closer the PPP will be (RIETI 2003). An example of this would be China and its domestic currency “Yuan” whose exchange rate does not reflect the actual purchasing power of other currencies. This way they increase exports and have huge economic growth. With a common currency for multiple countries such as the Euro, it is easier to compare prices, as no calculations have to be made. The purchasing power of the euro is different across different Euro-countries (destatis, 2009).

In theory, purchasing power parity theory is valid, yet it’s application has many limitations. It is an accurate explanation of why exchange rates change, but only for a certain basket of goods. Raw materials such as metals, diamonds and wood are easily traded and an international market equilibrium can be found fast. These goods are traded close to the real exchange rate. Non tradable goods such as packaged food are hard to trade and will be closer to the PPP exchange rate. Whether goods are of equal quality makes is a strong limitation to whether the chosen goods can really be compared. PPP is only a valid theory in the long run, as people take time to have to recognise and exploit the price differences. With a common currency across multiple countries such as the Euro, this reduces this greatly. Lastly government intervention with regulations, import taxes and tariffs affect the PPP as it makes buying foreign products more expensive.