Purchasing-power parity theory.

A theory which states that the exchange rate between

one currency and another is in equilibrium when their domestic purchasing powers at that rate
of exchange are equivalent.
In short, what this means is that a bundle of goods should cost the same in Canada and the United
States once you take the exchange rate into account. To see why, we'll use an example.

Purchasing Power Parity and Baseball Bats

First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the
exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell
for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15
USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in Mexico, so consumers are
much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to
see three things happen:
1.

American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go
to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw
in "A Beginner's Guide to Exchange Rates" this will cause the Mexican Peso to become more
valuable relative to the U.S. Dollar.

2.

The demand for baseball bats sold in the United States decreases, so the price American
retailers charge goes down.

3.

The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge
goes up.

Eventually these three factors should cause the exchange rates and the prices in the two countries to
change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8
MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball
bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a
consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it
for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.

Purchasing Power Parity and the Long Run

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in
the long run as market forces will equalize prices between countries and change exchange rates in
doing so. You might think that my example of consumers crossing the border to buy baseball bats is
unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat
for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or
thousands of the bats in Mexico then shipping them to the United States for sale. It is also not
unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico
instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United
States and Mexico is not sustainable because an individual or company will be able to gain an
arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other
market (This is explained in greater detail in What is Arbitrage? ).
Since the price for any one good should be equal across markets, the price for any combination or
basket of goods should be equalized. That's the theory, but it doesn't always work in practice. We'll
see why on page 2.

Definition of 'Purchasing Power Parity - PPP'

An economic theory that estimates the amount of adjustment needed on the
exchange rate between countries in order for the exchange to be equivalent to
each currency's purchasing power.
The relative version of PPP is calculated as:

Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2
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Investopedia explains 'Purchasing Power Parity - PPP'

In other words, the exchange rate adjusts so that an identical good in two
different countries has the same price when expressed in the same currency.
For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost
US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is
1.50 USD/CDN. (Both chocolate bars cost US$1.00.)

What is Purchasing Power Parity?

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when
their purchasing power is the same in each of the two countries. This means that the exchange rate between two
countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a
country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must
depreciated in order to return to PPP.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive
markets will equalize the price of an identical good in two countries when the prices are expressed in the same
currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US
Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV
in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process
(called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again
the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers
to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and
services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses,
and many services that are local, are of course not traded between countries.

Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described
in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate
between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in
the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD.
If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger)
against the USD, and the USD will in turn depreciate (get weaker) against the CAD.

Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of
appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For
example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate
against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation

differences are large.

Does PPP determine exchange rates in the short term?

No. Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes
in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP,
by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually
equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would
be typical.

How is PPP calculated?

The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard"
good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of
PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated
versions of PPP look at a large number of goods and services. One of the key problems is that people in different
countries consumer very different sets of goods and services, making it difficult to compare the purchasing power
between countries.

According to PPP, by how much are currencies overvalued or undervalued?

The following two charts compare the PPP of a currency with its actual exchange rate relative to the US Dollar and
relative to the Canadian Dollar, respectively. The charts are updated periodically to reflect the current exchange rate. It
is also updated once a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the
Organization of Economic Cooperation and Development (OECD) and others; however, they should not be taken as
"definitive". Different methods of calculation will arrive at different PPP rates.

The currencies listed below are compared to the US Dollar. A green bar indicated that the local currency is overvalued
by the percentage figure shown on the axis; the currency is thus expected to depreciate against the US Dollar in the
long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against
the US Dollar in the long run.

The currencies listed below are compared to the Canadian Dollar. A green bar indicated that the local currency is
overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Canadian
Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to
appreciate against the Canadian Dollar in the long run.

The currencies listed below are compared to the European Euro. A green bar indicated that the local currency is
overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Euro in
the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate
against the Euro in the long run.