Purchasing Power Parity (PPP)

PURCHASING POWER PARITY

I INTRODUCTION

Purchasing power parity (PPP ) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries . This theory is based on an extension and variation of the "law of one price " as applied to the aggregate economy . To explain the theory it is best , first , to review the idea behind the law of one price

The Law of One Price (LoOP

The idea between the law of one price is that identical goods selling in an integrated

market , where there are no transportation costs or differential taxes or subsidies , should sell at identical prices . If different prices prevailed then there would be profit-making opportunities by buying the good in the low price market and reselling it in the high price market . If entrepreneurs acted in this way , then the prices would converge to equality

Of course , for many reasons the law of one price does not hold even between markets within a country . The price of beer , gasoline and stereos will likely be different in New York City than in Los Angeles The price of these items will also be different in other countries when converted at current exchange rates . The simple reason for the discrepancies is that there are costs to transport goods between locations , there are different taxes applied in different states and different countries , non-tradable input prices may vary , and people do not have perfect information about the prices of goods in all markets at all times . Thus , to refer to this as an economic "law " does seem to exaggerate its validity

From LoOP to PPP

The purchasing power parity theory is really just the law of one price applied in the aggregate , but , with a slight twist added (more on the twist a bit later . If it makes sense from the law of one price that identical goods should sell for identical prices in different markets then the law ought to hold for all identical goods sold in both markets . Absolute purchasing power parity is a form of PPP where the exchange rate will equal the ratio of the costs of the two market baskets of goods denominated in local currency units . Note that the reciprocal relationship is also valid

Because the cost of a market basket of goods is used in the construction of the country 's consumer price index , PPP is often written as a relationship between the exchange rate and the country 's price indices However , it is not possible merely to substitute the price index directly for the cost of the market basket used above . To see why , let 's review the construction of the CPI

The Consumer Price Index (CPI ) and PPP

The CPI is an index that measures the average level of prices of goods and services in an economy relative to a base year . In to track only what happens to prices , the quantities of goods purchased is assumed to remain fixed from year...