Purchasing Power Parity Analysis
Purchasing Power Parity Analysis
Paul Streeten defying Purchasing Power as: “The amount of goods and services bought by a unit of currency. It is therefore the reciprocal of a price index: when prices go up, purchasing power falls”. In addition, he establishes that Purchasing Power Parity (PPP) is the theory that exchange rates between currencies are determined, in equilibrium or in the long run, by the amount of goods and services that a currency can buy. If £1 in Britain buys what $1.50 buys in the United States, the equilibrium exchange rate would be £1 = $1.50”.
The theory was propounded by the Swedish economist Gustav Cassel (1866–1944) in 1916 when a system of free exchange rates prevailed. If the prices of tradable goods are lower in one country than in another, allowing for transport costs and tariffs, people buy these cheaper goods and sell them in the dearer country. In the cheaper country the prices of goods or the value of the exchange rate will rise. But not all goods and services are tradable (e.g., government services), and transport costs, tariffs, capital movements, and government policies interfere with the long-term tendency to equality of the purchasing power of different currencies.
One of the foundations of international economics is the theory of Purchasing Power Parity, which states that price levels in any two countries should be identical after converting prices into a common currency. As a theoretical proposition, PPP has long served as the basis for theories of international price determination and the conditions under which international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept. (Pakko & Pollar, 2003). Another version of the theory explains changes in the exchange rate by changes in the relative purchasing power of the currencies. The explanation of the exchange rate is that it depends on supply and demand, and purchasing power is only one of many factors
Paul Streeten defying Purchasing Power as: “The amount of goods and services bought by a unit of currency. It is therefore the reciprocal of a price index: when prices go up, purchasing power falls”. In addition, he establishes that Purchasing Power Parity (PPP) is the theory that exchange rates between currencies are determined, in equilibrium or in the long run, by the amount of goods and services that a currency can buy. If £1 in Britain buys what $1.50 buys in the United States, the equilibrium exchange rate would be £1 = $1.50”.
The theory was propounded by the Swedish economist Gustav Cassel (1866–1944) in 1916 when a system of free exchange rates prevailed. If the prices of tradable goods are lower in one country than in another, allowing for transport costs and tariffs, people buy these cheaper goods and sell them in the dearer country. In the cheaper country the prices of goods or the value of the exchange rate will rise. But not all goods and services are tradable (e.g., government services), and transport costs, tariffs, capital movements, and government policies interfere with the long-term tendency to equality of the purchasing power of different currencies.
One of the foundations of international economics is the theory of Purchasing Power Parity, which states that price levels in any two countries should be identical after converting prices into a common currency. As a theoretical proposition, PPP has long served as the basis for theories of international price determination and the conditions under which international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept. (Pakko & Pollar, 2003). Another version of the theory explains changes in the exchange rate by changes in the relative purchasing power of the currencies. The explanation of the exchange rate is that it depends on supply and demand, and purchasing power is only one of many factors
References: Pakko, M. R. and Pollard, P S. (1996) “For Here or To Go? Purchasing Power Parity and the Big Mac.” Federal Reserve Bank of St. Louis Review, January/February1996, 78(1), pp. 3-22. Pakko, M. R. and Pollard, P S.(2003) “Burgernomics: A Big Mac Guide to Purchasing Power Parity” Federal Reserve Bank of St. Louis Review Rogoff, Kenneth. “The Purchasing Power Parity Puzzle”. Journal of Economic Literature, June 1996, 34(2) pp. 647-68. Shapiro, A.C. (1998). Foudations of Multinational Financial Manangement. Prentice-Hall Inc. London. Streeten, P. (2001). "Purchasing Power Parity" The Oxford Companion to the Politics of the World, 2e. Joel Krieger, ed. Oxford University Press Inc.. Oxford Reference Online. Oxford University Press. Apollo Group. Retrieved 22 July 2008 http://www.oxfordreference.com/views/ENTRY.html?subview=Main&entry=t121.e0632