Purchasing Power Parity

When there are no significant costs or other barriers associated with moving goods or services between markets, then the price of each product should be the same in each market. In economics, this is known as the law of one price. When the different markets represent different countries, the law of one price says that prices will be the same in each country after making the appropriate conversion from one currency to another. Alternatively one can say that exchange rates between two currencies will equal the ratio of the price indexes between the countries. In international finance and trade, tins relationship is known as the absolute version of purchasing power parity.

In reality, we know that this relationship does not hold because of the costs of moving goods and services and the existence of tariffs and other trade barriers. For example, The Economist newspaper, m a lighthearted look at the law of one price, regularly reports on the price of Big Mac hamburgers in various countries. In 1991, a Big Mac cost $2.20 in the United States, $2.56 in Germany, $1.36 in Yugoslavia, $1.10 in Hong Kong, 6.25 in Russia, and $2.32 in Japan. It is obviously not possible to buy Big Macs in Hong Kong and ship them to New York for sale, for example. Hence the law of one price does not hold for Big Macs. On the other hand, for goods that are standardized and somewhat easier to move and store, such as gold or crude oil, one would expect only minor violations of the law of one price.

A less restrictive form of the law of one price is known as relative purchasing power parity (PPP) The relative PPP principle states that in comparison to a period when exchange rates between two countries are in equilibrium, changes in the differential rates of inflation between two countries will be offset by equal, but opposite changes in the future spot exchange rate. For example, if prices in the United States rise by 4 percent per year and prices in Germany rise by 6 percent per year, then relative PPP holds if the Gentian Mark (DM) weakens relative to the U S dollar by approximately 2 percent.

The exact relative purchasing power parity relationship is:

(3.5)

where, S₁ is the expected future (direct quote) spot rate at time period 1, S₀ is the current (direct quote) spot rate, π_h, is the expected home country (US) inflation rate, and π_f is the expected foreign country inflation rate. This relationship can be simplified to:

(3.6)

Using the example above, if U.S. prices are expected to rise by 4 percent over the coming year, prices in Germany are expected to rise by 6 percent during the same time, and the current spot exchange rate (S₀) is $0.60/DM, then the expected spot rate in one year (S₁,) will be

S₁/$0.60 = (1+0.04)/(1+0.06)

S₁ = $0.5887

The higher German inflation rate can be expected to result in a decline in the future spot value of the DM relative to the dollar by 1.89 percent

The market forces that support the relative PPP relationship operate in the following way. If one nation has a higher inflation rate than another, its goods and services will become relatively more expensive, making its exports less price competitive and imports more price competitive. The resulting deficit in foreign trade will place downward pressure on the currency value of the high inflation country until a new, lower equilibrium value is established. The opposite will be true for the country with the lower inflation rate. For example, if the United States has a lower inflation rate than its major trading partners, relative PPP indicates that the value of the dollar can be expected to increase relative to the value of the currencies of these other trading partners.

Tests of relative PPP indicate that the relationship holds up reasonably well over long periods, but it is a less accurate indicator of short-term currency value changes. Also, the relative PPP relationship is stronger for those countries experiencing high rates of inflation. Tests of the strength of the PPP relation­ship are hampered by the use of noncomparable price indexes between countries and government interference in commodity and currency markets. Nevertheless, the general relationship between inflation rates and currency values is widely accepted, even if it is difficult to measure properly.