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By comparing the prices of a basket of items, theoretically, it can be determined if prices, and therefore currency strength is too high or too low in a country.
If prices are lower in a country, the currenct will rise in value as money flows into the country from countries with higher prices
If prices are higher in a country, the currency will drop in value as money flows out of the country into countries with lower prices.
There are several versions of the PPP. Some models takes into account not only real prices differences, but also income levels, inflation rates and costs of living. The goal is to try and compare not only what the basket of items cost in real conversion rates, but what it costs compared to what people can afford to buy.
Let’s look at a single example-
Lets say the exchange rate for Yen to dollars is 90 Yen per dollar.
Let’s also say that a widget costs $20 in the US, but in Japan it costs 900 Yen.
This means in USD the Widget costs $20 in the US, but it costs only $10 in Japan.
Since the widget is half the price in Japan than it is in the US, people would rather buy the widget from Japan.
This means that the demand for widgets from japan would rise, causing the price of widgets to rise in Japan.
This also means that the demand for widgets from the US would fall causing the price of widgets in the US to drop.
More demand for Widgets in Japan would mean that, as people buy more widgets in Japan, more currency is being exchanged from other currency into Yen, causing Yen to rise in value.
Less demand for widgets in the US mean that, as less people are buying Widgets in the US, less foreign currency is being exchanged into dollars, causing dollars to fall.
While a single item probably has little if any real effect on the exchange rate between 2 currencies, if the overall trade cost is cheaper from one place than another, it is extremely logical to assume that the country with cheaper prices will see an increase of trade, and therefore will see the value of their currency rise, and the country with more expensive prices will see trade decline and therefore value of their currency fall in value.
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There are several variations of the PPP, including the Big Mac index. Instead of a basket of goods, the Big Mac Index compares the price of a Big Mac from country to country as an indicator of the level of cost per country.
If the price of a big mac costs more in a country, theoretically, the prices, and in turn the currency, is overpriced and the currency should drop in value over time.
If the price of a big mac costs less in a country, theoretically, the prices, and in turn the currency is underpriced, and the currency should rise in value over time.
When comparing a Bic Mac index to the actual PPP chart, it is strikingly similar.
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Like all economic theories, the PPP has its problems.
The first is that it is difficult to find a set of items to compare prices between countries, because people in different countries typically consume different goods.
Second is that it is difficult to compare real purchasing power between countries, due to the vast number of factors that effect purchasing power.
The third is that is is a longer term theory.
It can take several years for currencies to react to price differences.
In the short term, it is easy to find examples where the PPP does not work.
The fourth is that PPP assumes free trade is in place, and does not take into account things like taxes, tariffs, or quotas.
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So that’s the PPP.
In my next video, I’ll cover another model that is based in part on the PPP- The Monetary Model.
See you then.
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Kevin MacLeod
incompetech.com
