Definition Of Purchasing Power Parity

Purchasing power parity and exchange rates

Purchasing power parity (PPP) is an economic theory mainly concerned with the reliability of spot exchange rates between two currencies. The theory attempts to explain the continual shifting of exchange rates between currencies based on the relative value of each currency and their respective inflation rates. Based on the theory of one price, PPP explains how numerous currencies can exist in a global market without a select few eventually overpowering all others.

Significance

The fundamental concept behind the theory of purchasing power parity is the belief that the ratio of the prices of a single product or a selection of products in both currencies should represent the official currency-exchange rate. When this is true, the two countries are said to be at parity or equilibrium.

For example, if the exchange rate between the U.S. dollar and Canadian dollar is 1.50 USD per 1 CAD, then a product that costs $1.50 USD in the USA should cost $1 CAD in Canada. When this is the case, the two currencies are at parity and the exchange rate is expected to remain generally constant.

Expectations

According to the University of British Columbia Sauder Business College, the exchange rate between two currencies is expected to shift when the ratio of actual prices differs from the official exchange rate. When exchange rates favor one currency over another such that the price of a benchmark product is less expensive in real terms compared to another currency, then the first currency can be expected to devalue against the second until parity is reached.

Comparative price levels and PPP statistics on all member countries of the Organization for Economic Co-Operation and Development (OECD) are available online.

Considerations

As with a great number of economic theories, purchasing power parity is based on assumptions that are only relevant in a static, lab-controlled world. The real world includes uncontrollable variables, such as transportation costs, political barriers to trade and raw material availability, that may skew the calculations. Recent events have also shown that single economies can take unexpected plunges due to such factors as corruption and dependence on large organizations that are prone to fail, which presents specific challenges to the theory.

Relative Purchasing Power Parity

Relative purchasing power parity takes PPP a step further by accounting for differences in inflation rates between two currencies. The theory asserts that if one currency’s inflation rate is higher than another’s, the exchange rate should shift to compensate for the extra devaluation of the currency with the higher rate of inflation.

Calculations

According to investopedia.com, the formula for determining the purchasing power parity between two currencies is:

Spot Exchange Rate = Price in Currency 1 / Price in Currency 2

The formula for determining relative purchasing power is:

S1 / S2 = (1+Iy) / (1 + Ix)

where S1 = the exchange rate at the end of the period; S2 = the exchange rate at the beginning of the period; Iy = the expected annual inflation rate for the foreign country; Ix = the expected annual inflation rate for the home country.