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Purchasing Power ParityBig Mac Index - Essay Example

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In its strictest definition, the theory of the purchasing power parity states that, "the exchange rate between countries' currencies equals the ratio of their price levels, as measured by the money prices of a reference commodity basket" (Krugman and Obstfeld, 2000)…
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Purchasing Power ParityBig Mac Index

Download file to see previous pages... The purchasing power parity or the PPP is also loosely explained as the Big Mac index, as introduced by The Economist in the mid-1980s. In the absolute definition of PPP, the Big Mac, a consumer good sold in practically every part of the world, takes the place of the commodity basket. Using this route gives a more simplistic definition of the theory. Therefore, a Big Mac being sold in the United States must have the same price as Big Mac sold in Australia, for example.
Looking at PPP with a monetary approach to the exchange rate will show the behavior of exchange rate in the long run, in terms of the supply of and demand for money. An increase in the national interest rate results in the depreciation of the national currency. Likewise, an appreciation of the country's currency will be resulted by a decrease in the national interest rate.
However, recent data cannot fully support the theory of the purchasing power parity and the law of one price. In the real world, there are trade barriers, free competition, and differences in price levels in different countries, giving rise to difficulty in testing the PPP through government-published price indexes. There are also certain products and services that have consequently become non-tradable goods because of steep international transport costs.
The PPP can also be viewed as a country's real exchange rate, wherein a foreign commodity basket is valuated in terms of a domestic commodity basket. Having all other factors equal, a country's local currency will undergo a long-run appreciation vis--vis foreign currencies, an ensuing scenario when the world demand for this particular country's output increases.
The more common notion of purchasing power parity must be distinguished from a related theory known as relative purchasing power parity, wherein the relationship between the relative inflation rates of two countries and the change in the exchange rates of their currencies comes into play.
An exchange rate that is determined by purchasing power parity gives rise to an equalization of the purchasing power of different currencies in a particular home country. Despite the fluctuations in the market exchange rates, PPP exchange rates are reflected in the long run. However, the difference between the market exchange rates and the PPP exchange rates can be somewhat significant. See this example: The World Bank's World Development Indicators 2005 estimates that one United States dollar is equivalent to approximately 1.8 Chinese yuan by purchasing power parity in 2003. However, based on nominal exchange rates, one U.S. dollar is currently equal to 7.9 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800, while on a PPP basis it is about US$7,204. This is frequently misused to assert that China is the world's second largest economy, but such a calculation would be invalid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.
The proper estimation of purchasing power parity is made difficult because there is no uniform price level. Also, different people in different countries have varying commodity baskets, ...Download file to see next pagesRead More
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