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. 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 examp le, 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. The term parity is sometimes used in the context of exchange rates. When the gold standard was in force under the Bretton Woods agreement, which governed exchange rates of International Monetary Fund (IMF) members for nearly three decades after World War II (1939-1945), the mint parity was the exchange rate between two currencies in relation to how much gold each could buy. For example, if £1 bought the same amount of gold as $2, the mint parity was £1=$2. Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca (West central Spain) in the 16th century and was developed in its modern form by Gustav Cassel in 1918. 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. The best-known and most-used purchasing power parity exchange rate is the Geary- Khamis dollar (the "international dollar"). PPP exchange rate fluctuations are mostly due to different rates of inflation between the two economies. Aside from this instability, consistent deviations of the market and PPP exchange rates are observed, for example… prices of non-traded goods and services are usually lower where incomes are lower. As U.S. dollar exchanged and spent in Pakistan will buy more haircuts than a dollar spent in the United States. PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. PPP rate fluctuations are mostly due to different rates of inflation in the two economies which would result in the difference in prices at home and abroad. There can be marked differences between PPP and market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese Yuan by purchasing power parity — considerably different from the nominal exchange rate that put one dollar equal to 7.6 Yuan. This discrepancy has large implications; for instance, GDP per capita of China is about US$1,800 while PPP is about US$7,204. Reasons for diffe rent 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. Range and quality of goods: Local, non-tradable goods and services (like electric power) that are produced and sold domestically. Tradable goods such as non-perishable commodities that can be sold on the international market. PPP Measurement: The PPP exchange-rate calculation is controversial (disagreement) because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. 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. The average person in the richest region, North America, has an annual purchasing power of $33,410 in United States dollars, compared with only $1,960 for the average person in Africa. Critics of the way globalization has been implemented say that income inequalities are increasing rather than narrowing. 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. In securities, any deviations from the absolute form of purchasing power parity create opportunities for arbitrage? Profiting from inefficiencies in prices. See also: Purchasing power parity, Currency pair. 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. 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. According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the EUR should appreciate by 2% compared to the purchasing power of the USD (equivalently the USD will depreciate by about 2%). Note that it is incorrect to do the calculation by subtracting percentages - one must use the above formula, getting 1.01/1.03 = .98, i.e. a 2% depreciation of the USD. With larger price rises, the difference between the incorrect and the correct formula becomes larger.
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