18.3 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity

18.3 a. The Basic Logic of Purchasing-Power Parity

Purchasing power parity is an economic theory that states residents of one country should be able to buy the goods and services at the same price as inhabitants of any other nation over time [17].

Example: China produced $10.98 trillion in goods and services in 2015. The U.S. produced $17.95 trillion. Taking into account the fact that the cost of living in China is much lower than in the United States, under PPP, China’s GDP under PPP is $19.39 trillion. That makes it the world’s largest economy, ahead of the European Union and the United States [17].

^{Purchasing Power Parity [19]}

18.3 c. Limitations of Purchasing-Power Parity ^[18]

• Transport Costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will consequently sell at a relatively higher price than the same goods available from local sources.
• Taxes: When government sales taxes, such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country.
• Government Intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing the price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower. Governments that restrict exports will see a good’s price rise in importing countries facing a shortage, and fall in exporting countries where its supply is increasing.
• Non-Traded Services: The Big Mac’s price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of the storefront, and other expenses such as insurance, heating and the cost of labor.
• According to PPP, in countries where non-traded service costs are relatively high, goods will be relatively expensive, causing such countries’ currencies to be overvalued relative to currencies in countries with low costs of non-traded services.
• Market Competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices.
• The company’s sought-after brand might allow it to sell at a premium price as well. Conversely, it might take years of offering goods at a reduced price to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome.
• Inflation: The rate at which the price of goods (or baskets of goods) is changing in countries, the inflation rate, can indicate the value of those countries’ currencies. Such relative PPP overcomes the need for goods to be the same when testing absolute PPP

^{Limitations of Purchasing Power Parity [20]}