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The relative purchasing power parity theory states that the exchange rate between two nations is driven mostly by the different rates of inflation and the cost of products in both nations. This theory is based on the idea of purchasing power theory and propels the absolute purchasing power parity . The APPP states that ratio of price levels for two nations involved in trades would be equivalent to their currency exchange rates. Purchasing Power Parity is an idea that the cost of goods in one nation will be equivalent to the cost of the same good in another nation if their exchange rate is applied. This concept drives the notion that two countries have equal currencies if the cost of goods is the same in both countries. The purchasing power parity is determined by the comparison of the price s of similar products in different countries.
This modification was made because McDonald’s restaurants are only found in three African countries – Morocco, Egypt and South Africa – whereas KFC is found in 20. This means that the purchasing power of various African currencies can be compared to the US dollar, euro and pound. The KFC index was created by Sagaci Research to assess the purchasing power parities of African currencies. The index is based on the Big Mac index, but in this case, the basket of goods being measured is KFC’s original 15-piece bucket.
However, the theory ignores the existence of inflation and consumer spending, as well as transportation costs and tariffs, which can impact the short-term exchange rate. The economic theory of PPP is commonly used to compare the economic health of countries across the world. We take a look at the different types of purchasing power parity and how the theory applies to financial markets.
Next, let’s apply the above formula to calculate the expected change in the exchange rate due to an inflation differential between the two countries. The table below illustrates the necessary calculations using an Excel spreadsheet. In exchange rates can be explained by differences in inflation rates between countries over a certain period. Which implies that the value of A$ relative to B$ should depreciate by the same amount that the inflation in country A exceeds inflation in country B. Also, purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.
Purchasing Power Parity in Theory
The burger was chosen due to the global reach of McDonald’s, with an estimated 36,889 outlets in 120 countries. Although it’s worth noting that due to differences in ingredients, even this isn’t a perfect measure of PPP. For example, if the UK had an annual inflation rate of 2%, then one unit of pound sterling would be able to purchase 2% less per year.
However, in reality, there are transaction costs, government taxation and barriers to trade that prevent costs from equalising. Perhaps the most famous PPP index was devised by The Economist to measure how many units of a currency are needed to purchase a McDonald’s Big Mac – known as the Big Mac index. This is considered a fun-focused take on PPP but has nevertheless become extremely widely used. Once the value of a hamburger in each country is known, exchange rates can then be adjusted to show the purchasing power of each currency.
So, in countries that are labour-intensive, the real incomes and power of a currency might be several times higher than is suggested by the nominal GDP. Due to the large differences in price levels between developed and developing economies, it might not be enough to simply countries market rate converted GDP. One we add this concept onto APPP, we can see that inflation rates will account for part of the change in the power of currencies. So suppose that the UK has a 2% inflation rate, while Brazil has a 5% inflation rate. This means that after one year, the price of a basket of goods in Brazil has increased by 5%, while the same basket of goods in the UK has only increased by 2%.
Relative PPP
The Big Mac PPP is a survey done by The Economist that examines the purchasing power of various currencies based on the relative price of a Big Mac. The formula for purchasing power parity is Cost of Good X in Currency 1 / Cost of Good X in Currency 2. This allows an individual to make comparisons of currencies and the value of a basket of goods they can buy. A cup of coffee will have the same basic makeup regardless of where you buy it – coffee, water and milk – however the cost of each cup can vary hugely depending on where you buy it.
PPP thus implies that the exchange rate is determined by the ratio of average prices. A good starting point is the law of one price , which states that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. Intuitively, LOP holds because, if prices were lower in country A and higher in country B, people would simply buy the lower-priced good in country A and sell it in country B at a higher price. The PPP theory assumes that a decline in the purchasing power of a currency, caused by factors such as inflation, should equate to an equal fall in the exchange rate. Analysts use global PPP data to assess how changing price levels impact the number of individuals below the poverty line, and readjust the global estimates of how long it will be until poverty ends.
Purchasing power parity indices
By looking at the above charts, we can see that in 2014, GDP in PPP more accurately represents the patterns of carbon emissions in each country than GDP at the exchange rate at the time. For example, the nominal GDP would imply that the US is the largest output of carbon, whereas PPP conforms to the carbon data, showing China as the largest source. This is because the PPP is believed to reflect the industrial production of countries better. The assumption here is that tradable goods are more closely aligned with nominal exchange rates, while non-tradeable goods and services are closer to the PPP rate.
Purchasing power parity is important because it allows economists to compare two different economies, primarily the economic productivity and the standard of living among nations. Thus if a country has an annual inflation rate of 10%, that country’s currency will be able to purchase 10% less real goods at the end of one year. The risks of loss from investing in CFDs can be substantial and the value of your investments may fluctuate.
Relative purchasing power parity is an economic theory that states that exchange rates and inflation rates in two countries should equal out over time. Relative Purchasing Power Parity refers to the expansion of the purchasing power parity theory to involve inflation changes as time goes by. The amount of goods and services that one power of money can purchase is referred to as purchasing power. According to the RPPP, nations with higher inflations will have a lesser valued currency compared to their counterparts with lower inflation rates. Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing powers to be equal.
Unlike the absolute form of PPP, the relative form of PPP tells us the expected change in the exchange rate as a result of differences in countries’ inflation rate. In countries’ exchange rate should exactly offset the price effects of inflation differences between the countries. Suppose the US has an inflation rate of 2% and the Eurozone has an inflation rate of 0%, then the USD is expected to depreciate by approximately 2% relative to the Euro. The Balassa-Samuelson Effect is a pattern wherein countries with high productivity and wage growth also experience higher real exchange rates. This theory states that the real cost of a good must be the same across all countries after the consideration of the exchange rate.
Does purchasing power parity (PPP) hold in the long run?
RPPP also complements the theory of absolute purchasing power parity , which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. Moving from the law of one price to purchasing power party is also complicated by the fact that people in different countries consume different goods. Absolute PPP doesn’t hold, as shown by the fact that PPP exchange rates normally deviate from nominal exchange rates. RPPP is essentially a dynamic form of PPP, as it relates the change in two countries’ inflation rates to the change in their exchange rate.
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However, it is quick to dismiss this concept in the real world as purchasing power parity doesn’t account for price changes in the short-run and long-run. Also, another reason to dismiss PPP is due to the fact that it doesnt account for product quality, consumers behavior, and economic performance of each nation. RPPP is a dynamic form of PPP as it compares two nations change in inflation rate to the difference in their currency exchange rates.