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A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory)

A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory)

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[Q:] I am currently taking an economics class and we are now discussing purchasing power parity. I am lost, could you help me out?

[A:] Thanks for your question!

We'll take a look at the purchasing power parity theory (PPP theory) and show what the theory implies. The Dictionary of Economics published by The Economist defines purchasing-power parity theory as follows:

    Purchasing-power parity theory. A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account. To see why, we'll use an example.

Purchasing Power Parity and Baseball Bats

First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico. Clearly there's an advantage to buying the bat in Mexico, so consumers are much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to see three things happen:
  1. American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw in "A Beginner's Guide to Exchange Rates" this will cause the Mexican Peso to become more valuable relative to the U.S. Dollar.

  2. The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down.

  3. The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up.

Eventually these three factors should cause the exchange rates and the prices in the two countries to change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8 MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.

Purchasing Power Parity and the Long Run

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so. You might think that my example of consumers crossing the border to buy baseball bats is unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or thousands of the bats in Mexico then shipping them to the United States for sale. It is also not unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United States and Mexico is not sustainable because an individual or company will be able to gain an arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other market (This is explained in greater detail in “What is Arbitrage? ”).

Since the price for any one good should be equal across markets, the price for any combination or basket of goods should be equalized. That's the theory, but it doesn't always work in practice. We'll see why on page 2.

Be Sure to Continue to Page 2 of "A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory)".

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