Purchasing Power Parity – If we lived in a world of truly efficient markets then the price of a basket of goods would be the same in all countries. However, anyone who has taken a trip abroad knows that this is not the case. In fact prices for identical items vary quite widely across nations.
Imagine that a basket of goods cost $50 is the USA. Next, imagine that the same basket of goods costs €40 in France. Let’s assume that the exchange rate is €1 = $1.50. This means that the dollar value of the basket of goods in France is $60. In other words, French consumers must pay 20% more for the same basket of goods.
Now let’s imagine that the typical American worker earns $40,000 per year and the typical French worker earns €30,000 per year. On the face of it the French worker is better off – she earns a dollar equivalent of $45,000 per year. However, as we saw before, she must pay 20% more for the goods she wants to buy. To make the effect clearer, let’s see how many baskets of goods an American worker can buy each year and how many our French worker can buy. Our American worker can buy 800 baskets ($40,000/$50), our French worker can only buy 750 baskets (€30,000/€40). So, she is theoretically $5000 a year richer that her American counterpart, however, she is actually 50 baskets poorer. In order to have the same purchasing power as an American worker, the French worker would need a salary of €32,000 (800 X €40). This implies that the dollar is undervalued against the Euro.
The example above illustrates why comparing figures such as GDP in dollar value can be misleading. Economists acknowledge this by adjusting wages and GDP levels for purchasing power parity PPP. This gives a truer picture of the size of the economy and the spending power of a country’s citizens.
Purchasing Power Parity and Exchange Rates
Theoretically a basket of goods should be the same everywhere. The theory of purchasing power parity when applied to exchange rate prediction states that over time the basket of goods should become equal in price. This means that in order to equalize the exchange rate will change. In our example of the USA and France we started with a rate of €1 = $1.50, this gave a price equivalent of $60 for the $50 basket of goods. For the price of the basket of goods to be equal the Euro exchange rate would have to fall to €1 = $1.25.
In the long run there is some evidence that PPP parity does predict changes in exchange rates. However, is does not appear to have any predictive value over periods of less than five years. In addition there are other reasons why prices may differ between countries. These could be caused by government trade policies, sales taxes and international price discrimination as is practiced by many transnational companies.