Sunday, January 27, 2013

PPP

The Economist defines Purchasing Power Parity in the following way:

A method for calculating the correct value of a currency which may differ from its current market value. It is helpful when comparing living standards in different countries, as it indicates the appropriate EXCHANGE RATE to use when expressing incomes and PRICES in different countries in a common currency.

By correct value, economists mean the exchange rate that would bring DEMAND and SUPPLY of a currency into EQUILIBRIUM over the long-term. The current market rate is only a short-run equilibrium. Purchasing power parity (PPP) says that goods and SERVICES should cost the same in all countries when measured in a common currency.

PPP is the exchange rate that equates the price of a basket of identical traded goods and services in two countries. PPP is often very different from the current market exchange rate. Some economists argue that once the exchange rate is pushed away from its PPP, trade and financial flows in and out of a country can move into DISEQUILIBRIUM, resulting in potentially substantial trade and current account deficits or surpluses. Because it is not just traded goods that are affected, some economists argue that PPP is too narrow a measure for judging a currency's true value. 

 An intuitive description of the PPP is here.  More from Wikipedia is here.  My thoughts now follow:

In the US, for example, a nose ring costs $1.  In Great Britain, the same nose ring costs £4.  Also assume that it takes $2 to equal £1.  This infers that the cost of a nose ring in the US should be $2.  PPP assumes that in the long run the price of a nose ring in the US will rise to $2.  This is because entrepreneurs in Britain will buy nose rings in the US and sell them in Britain for an arbitrage profit.  (PPP assumes no transaction costs.)  

The PPP is a good way of comparing countries standard of living.  By expressing similar goods in the same currency prices, one can make conclusions about the country.  This is obviously a difficult task.   


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