PURCHASING POWER PARITY

• Equivalent buying power in different currencies:

A way of estimating national income by showing the number of currency units required to buy the same amount of goods and services in another country as one currency unit would buy at home.

PURCHASING POWER PARITY

• Parity (economics), equality of status, or equivalence. In economics and business the concept of parity is applied in a number of ways.

• One way of comparing standards of living between different countries is to look at gross domestic product (GDP) per head in terms of purchasing power parities (PPPs), which tells us about the cost of living in each country. The two indicators GDP and PPP measures the living standards of a country, can be substantially different. For example, GDP per head in Australia and in the United Kingdom is less than 50 percent of that in Switzerland, but living standards (PPP) in the United Kingdom and Australia are more than 76 percent of the level in Switzerland.|

PURCHASING POWER PARITY

In its "Absolute Version”, the purchasing power of different currencies is equalized for a given basket of goods.

In the "Relative Version”, the difference in the rate of change in prices at home and abroad - the difference in the inflation rates - is equal to the percentage depreciation or appreciation of the exchange rate.

PPP Measurement 

Reasons for different measures:• The main reasons why different measures do not perfectly reflect standards of

living are:

• PPP numbers can vary with the specific basket of goods used, making it a rough estimate.

• Differences in quality of goods are hard to measure and thereby reflect in PPP.

The PPP exchange-rate calculation is controversial (disagreement) because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Global Purchasing Power

Income disparities between the developed and the developing countries of the world are apparent in a map showing average purchasing power by region.

Absolute Purchasing Power Parity

A theory stating that the same good or service costs the same amount regardless of the currency in which it is measured. For instance, if 1 pound is equivalent to 2 dollars, and a widget costs 1 pound in England, then the absolute form of purchasing power parity would state that the same widget would cost 2 dollars in the United States. This concept is also called the law of one price.

The Absolute Purchasing Power Parity Hypothesis

Absolute Purchasing Power Parity (PPP) holds if, at a particular time t, the cost of a foreign country’s representative bundle translated into domestic terms equals the cost of the domestic representative bundle:

St = PtP*t (Absolute PPP)

As a theory of exchange rate determination, absolute PPP states that the exchange rate must adjust so that the foreign price level translated at the spot rate is the same as domestic price level.

Calculation of purchasing power parity

Purchasing power parity is a real value comparison between two currencies. In general, purchasing power parity calculations are used to gauge the spending power of macroeconomic indicators, such as GDP in real terms. But purchasing power parity may also be used to compare the spending power of two currencies against a basket of related goods, such as groceries. To calculate purchasing power parity, analysts use a ratio derived from the price of goods and compared to the prevailing foreign currency exchange rate.

Calculation of purchasing power parity

There is process of 4 steps by which purchasing power parity is calculated:

STEP 1:Determine which two currencies you would like to compare for purchasing power parity. Formula for calculating purchasing power parity is:S (purchase power parity ratio) = Price 1/Price 2

P1 refers to one price in a specific currency, and P2 refers to another price in a different currency.

STEP 2:Determine which product is commonly available in both countries. Comparing one common product.

STEP 3:Research the price of the product in both countries (P1 and P2) divides P1 by P2. The result is the price ratio for purchasing power parity.

STEP 4:Compare the result of the purchasing power parity to the currency exchange rate between both the countries. Recall that for purchasing power parity to exist, the exchange rate and the purchasing power parity ratio must be equal.

Relative Purchasing Power Parity

An expansion of the purchase power parity theory, which suggests that prices in countries vary for the same product but that they differ by the same proportional rate over time. The reasons suggested for this price difference include taxes, shipping costs and differences in product quality. Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate, according to the following formula: Where St is the spot rate in Foreign Currency/Domestic Currency and Pt is the price level in period t (foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasing power parity.

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