Purchasing power parity

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					              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
      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

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

       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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