Purchasing Power Parity (PPP) is an
economic hypothesis for
international trade.
PPP relies on the
assumption that there is
free trade between
countries, meaning that there are
no barriers to trade (
tariffs,
import quotas, etc.). What PPP tells us is that there is a
predictable relationship between
product price levels and
exchange rates, and in the
long run, the
relative prices of a certain
good or
service will be the same, after exchange rates are taken into
account.
This
equilibrium can be reached either by the prices within each country
adjusting, or by the exchange rate between the two countries changing, or, most
often, both. PPP can be used to describe how a
nation's general price
level must change to
reestablish some
desired exchange rate, given the level and
trend in
foreign prices.
There are some general
tendencies that
Purchasing Power Parity follows:
1. PPP
predicts well at the level of
one heavily traded commodity. PPP focuses on one
particular product, which will eventually reach an equilibrium price in the world, fulfilling the "
law of one price."
2. PPP predicts
only moderately well at the level of
all traded goods. PPP loses
accuracy as we
introduce more and more goods. There are many
technical difficulties with comparing
index numbers of different products, especially when we add those that
inevitably will have differing prices in different countries.
Examples of this could be those products having
significant transport costs or
technology differences.
3. PPP predicts
least well at the level of all products in the
economy. PPP cannot account for
nontraded products in the economy, thus cannot be a good
predictor for nation's GDPs or price
indices for products that account for GDP.
4. PPP predicts better
over the long run than the
short run.
5. PPP implies that countries with relatively
low inflation rates have currencies whose values tend to
appreciate in the
foreign exchange market. The
opposite is also true.
The
equation for PPP looks somewhat like this:
rs = P/Pf
where
rs is the exchange rate between two countries and
P and
Pf are product prices levels in the
home country and foreign country,
respectively.
For
those of you who
made it through this without
falling asleep, I
congratulate you. I recommend applying to
NYU's
Stern School of Business.