Purchasing Power Parity (PPP)

Sometimes known as the “law of one price”, Purchasing Power Parity (PPP) states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate. Therefore, the exchange rate must move towards a long-term equilibrium value that ensures this is true. The formula is as follows:

PPP = Local price of goods/Foreign price of goods

For example, the price of a Big Mac in the US is US$2 and in Malaysia, RM5. Therefore, PPP = 5/2 = 2.5. At the time of writing, the exchange rate is US$1 = RM3.7. Thus, this suggests that the Malaysian Ringgit is undervalued relative to PPP and should appreciate over time to return to the equilibrium level.

Note that this is just a simplification of the whole thing, and if there are no transport costs or service tax involved, Americans will know that the Big Mac in Malaysia is cheaper and they will fly to Malaysia to buy it and fly back again. Obviously, this is not realistic, but the concept still holds true in international trade which will lead to the appreciation of the Ringgit over time:

Cheap Currency -> Goods appear cheaper and attracts buyers -> Increased demand for goods in Ringgit -> Currency appreciates

Also, we just can’t take PPP into account without knowing its limitations. If there’s a perfect free market economy, immediate price adjustments would happen if there are price differences in a good as this would create an arbitrage opportunity. However, this does not happen because of several factors:

No perfectly free trade – no country in the world has zero import tariffs, zero export subsidies and perfect competition across all business sectors.

Adjustment mechanism not immediate – corporations delay setting prices until they know the appropriate levels to be competitive and profitable at the same time.

Inconsistency of the good – quality, cost of a good may be different in 2 countries

Still, the PPP gives a useful medium to long-term perspective of currency valuations and is extremely easy to use. The well-known Big Mac Index by the Economist is an application of the PPP.

This entry was posted on Wednesday, October 18th, 2006 at 12:37 pm and is filed under Fundamentals, Theory, FOREX. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.