‘Purchasing Power Parity (PPP) is a method for calculating the correct value of a countries currencies which may be different from its current market value’ (McBride, n.d.).
To better understand PPP, it is important to first understand what Purchasing Power is. Purchasing Power describes the amount and quality of goods or services that one can buy with a certain amount of money. For example, if one had taken one unit of the pound to the store, it is possible to have bought a greater amount of goods than it would today, indicating that one would have had greater purchasing power in the 50s than now (Wikipedia, 2017).
Purchasing Power Parity (PPP) is based on the ‘law of one price’ and assumes that, in the presence of perfect market competition and the absence of transportation cost and other trade barriers, it should cost the same amount of money to purchase a particular basket of goods irrespective of the country of purchase, thus, the price of a basket of goods in country A should be same as the price of an similar/identical item in country B after converting to a common currency.
PPP is based on the idea of a perfect goods arbitrage, where economic market forces take advantage of price differentials in different international markets (Pilbeam, 2013, pg. 126). It compares different countries’ currencies through a basket of goods approach (Investopedia, 2016). For example if a Lenovo computer in Ghana cost Ghs1,000 and an identical Lenovo computer cost GBP250 in the UK, then according to the law of one price, the exchange rate should be Ghs4/”1. If the exchange rate was higher than this, say Ghs5/”1, it would be cheaper to purchase the computer from UK at ”250 and sell in Ghana Ghs1, 250, making a gain of Ghs250. On the other hand, if the exchange rate reduced to Ghs3/”1, then it will be cheaper to purchase an identical Lenovo computer in Ghana at Ghs750 and sell in the UK for ”250, thus making a gain of ”62.5.
Thus the arbitrage exploitations will interplay until an equilibrium is restored back to Ghs4/”1.Advocates of PPP argue that exchange rates must adjust to ensure that the law of one price applies.
There are two forms of PPP namely Absolute and Relative Purchasing Power Parity.
Absolute Purchasing Power Parity
Absolute PPP assumes that one’s purchasing power of similar and identical goods is same in all countries. Mathematically, can be stated as:
S=P/P*, where;
S is the PPP exchange rate defined as domestic currency units per foreign currency,
P is the price of a basket of goods expressed in domestic currency, and
P* is the price of an identical basket of goods from a foreign country.
The theory assumes that a rise in the domestic price levels to the foreign currency will result in a proportionate depreciation of the domestic currency against the foreign currency. This position is criticized as not holding true.
Relative Purchasing Power Parity
Relative PPP on the other hand is more dynamic and takes inflation into account. It has been argued that Relative PPP is more likely to hold irrespective of the effects of transport cost, market distortions and trade restrictions. This is expressed mathematically as:
%’S= %’P-%’P*, where;
%’S is the percentage change in exchange rate,
%’P is the percentage in domestic inflation rate, and
%’P* is the percentage change in the foreign inflation rate.
According to Relative PPP theory, if the inflation rate in the USA is 5% and the inflation in the UK is 3%, then the dollar to pound exchange rate should be expected to depreciate by approximately 2%.
Criticisms of the PPP Theory
Purchasing Power Theory as an economic model is often criticized as not holding true as it does not take the transport cost, trade barriers, transaction costs and perfect competition considerations into account. Some of the criticisms of the PPP theory are as discussed below.
The different types of goods traded on the international market
‘One major criticism of the PPP theory is that it suggests that PPP holds true for all types of goods. However, categorizing goods into traded and non-traded goods challenges the more generalized version of PPP and provides some useful insights into the distinction of goods’ (Pilbeam, 2013, p. 140)
Traded goods such as cars and computers are easy to transfer from country to country and are susceptible to the rigors of international completion such as brand or quality of manufacture.
Non-traded goods are those that cannot be traded internationally at a profit, such as houses and certain services such as haircut or restaurant food.
The point of the traded and non-traded goods is that PPP is more likely to hold for traded goods whose prices tends to be kept in line with international competition, while the price of non-traded goods is determined largely by domestic demand and supply considerations. For example if a Lenovo laptop computer Ghs1,000 in Ghana and GBP250 in the UK, arbitrage forces will interplay to keep the Cedi and Pound at Ghs4/”1. However, if a particular restaurant food cost say Ghs100 and an identical food cost ”20 in the UK, then at an exchange rate of Ghs5/”1 it is about ”5 cheaper to buy the food in the UK. However, it will not make economic sense to travel from Ghana to the UK to have a meal and back.
The distinction between traded and non-traded goods in PPP critique is important because aggregate price indices of a countries GDP is made up of both tradable and non-tradable goods.
Again, ‘PPP theory is based on the concept of comparing identical basket of goods in two economies. However an important problem researchers face is that different countries attach different weights to different categories of goods and services when constructing their price indices, which means that it is difficult to compare like with like when testing for PPP’ (Pilbeam, Pg. 140, statistical problems)
Transportation cost and trade restrictions
PPP theory assumes no transportation costs from one country to the other. Studies have shown that PPP holds for countries that are geographically close and with some trade linkages. However, trading of goods from one country to the other is characterized by some level of transportation cost as well as trade restriction and therefore the assertion of no transport cost or trade restrictions does not hold true.
Imperfection competition
PPP assumes that there is sufficient international competition to prevent arbitrage pricing of goods and services from one country to the other. However, the conditions necessary for price discrimination such as monopoly, consumers’ willingness to pay different prices for a particular goods or service or the ability to prevent resale are likely to hold from country to country. For example, considerable variations in the degree of international competition could mean that multinational corporations can often get away with charging different prices in different countries
Empirical Evidence on PPP
Referring to the graphical evidence displayed in ‘figure 6.1(a-g)’ Pilbeam 2012:pg131-134, shows the actual exchange rate and the exchange rate that would have maintained PPP for various currencies. The figures show actual exchange rate and PPP rates show comparisons between the dollar, pound, lira, deutschmark and French franc over a 39year period from 1973 to 2012.
Figure 6.1(a) shows considerable divergence between PPP and actual exchange rate. The figure shows periods of dramatic appreciation or depreciation in the dollar to pound rate as a result of inflation.
In Figure 6.1 (d-h) which shows tracking of the lira, French franc and pound against the deutschmark, the plots reveal small deviations from PPP against the dollar. This can be explained by the fact that transport cost and trade barriers between France, Italy, UK and Germany are small because of geographical proximity and the prohibition of trade barriers among EU member countries. These conditions facilitate the good market arbitrage the PPP heavily depends on
In figure 6.1(g), the plots reveal that although PPP deviates from actual exchange rate, it does have the tendency to go back towards PPP rates over the long run. This proves that PPP may be a useful guide to determine exchange rates over the long run.
Notwithstanding the criticisms of the PPP theory, PPP is a better measure of the Gross Domestic Product (GDP) between different countries compared to market exchange rates which turns to be influenced by inflation, government intervention, hedging, market speculations and different interest rates.