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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.
    PURCHASING POWER PARITY

•   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 example, 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.|
PURCHASING POWER PARITY


 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.
    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.


Reasons for different 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.
  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.
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.
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.
   Calculation of purchasing power parity
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.
THE END

								
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