Purchasing Power Parity (PPP)
The "Purchasing Power
Parity" theory claims that the exchange rate of
two currencies should mean that one currency has the same purchasing
power in any part of the world.
If you can buy a television for $1000
in the USA, with the same amount of money you should be able
to buy one in Spain, Japan or Asia.
The international referee
is the person that ensures that this law is fulfilled:
The international referee is backed
up by numerous investors and speculators that observe the international
markets looking for "bargains": differences in price
between two markets that allows people to buy things for less
money in one place and then sell for more in another, therefore
making a profit without running any risks.
If the purchasing power parity is not fulfilled,
this allows the referees to carry out their operations of buying-selling,
and the same person makes the exchange rate move until it fulfills
the parity law.
Let's look at an example:
Let's suppose that the exchange rate
Yen/$ is 100 (with one dollar you can buy 100 yens) and that
the same car in the USA costs 10.000 dólares and in Japan 900.000
yens.
The price of this car in the Japanese
market (converting it into dollars) would be 9000 dollars, which
would make the American car sellers import this car from Japan
and then sell it in the USA, making a profit of 1000 dollars,
simply because of the difference in price.
This will cause a great increase
in yens because of the American import companies, which will
make it appreciate. The balanced exchange rate will be reached
when the price expressed in dollars is the same in both markets.
900.000
yens / Exchange rate = 10.000 $
Then the balanced exchange rate =
900.000 / 10.000 = 90 Yens/$
With this new exchange rate, the price
of this car (expressed in dollars) will be the same in Japan
as in the United States (10.000 dólares).
As the level of prices vary according to the
country, the nominal exchange rate (the rate that we all know
and which does not alter prices) will have to adjust to the differences
in prices and ensure parity is achieved.
This adjustment in the nominal exchange
rate will allow the real exchange rate to remain constant, maintaining
purchasing power parity.
Let's continue with the previous example:
To start with lets take the balanced
exchange rate as (90 yenes/$). After a year the prices in the
USA go up by 5% and in Japan they go up by 10% (if we consider
the prices in both countries with a base of 100 at the start
of the year, after this year the index will be 105 in USA and
110 in Japan).
Bearing inflation in mind, the price
of a car will now be 10.500 dollars in the American market and
990.00 yens in the Japanese market.
The new nominal interest rate to
ensure Purchasing Power Parity is:
990.000 yens / Exchange
rate = 10.500 $
Then, the new balanced interest rate
will be = 990.000 / 10.500 = 94,28
Yens/$
The exchange rate of the yen compared
with the dollar will have deflated to compensate for the increase
in prices.
The variation of the nominal exchange rate responds
to the following formula:
Tcr = Tc * (Pext
/ Pint)
In this equation:
"Tcr" = Real exchange rate
"Tc" = Nominal exchange rate
"Pext" = Level of prices abroad
"Pint " = Level of prices
in the country
We are now going to apply this formula to the
example that we are looking at:
Tc = 90 * 110 / 105
= 94,28
In real life, the theory behind Purchasing Power
Parity has proved valid in general terms, but determined factors
make it difficult for it to happen:
Services that are difficult to
commercialize: a hair
cut can be more expensive in Madrid than in Paris.
Other goods can be commercialized
but their transport costs are very high: a brick can be
more expensive in France than in Spain but the transport costs
probably overcome the difference in prices.
