Foreign Exchange and Global Finance: Purchasing Power Parities

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Definition
Purchasing Power Parity is the technique used by economists to determine the relative value of currencies in different nations. The amount of goods and services that can be purchased in one country in that currency varies from the amount of goods and services that can be purchased in a different country for an equivalent currency. This variation is based on the availability of goods, demand for goods, and several other factors which are difficult to determine. PPP solves this problem by utilizing a common measure and then determining the cost for that measure in each of the two different currencies and then comparing the amount. In the absolute version, the purchasing power of different currencies is equalized for a given basket of goods. In the relative version, the difference in exchange rate between two countries which is the difference in inflation rates is equal to the percentage appreciation or depreciation of exchange rate. The relative PPP states that the country with the higher inflation rate is the weaker currency.
The relative version of PPP is calculated as:
S = P1/P2
Where:
S represents the exchange rate of currency 1 to currency 2
P1 represents the cost of goods in currency 1
P2 represents the cost of goods in currency 2
However, in the real world, these concepts do not always hold true. This is because the concept of purchasing power parity is based on unrealistic assumptions.
• PPP assumes that consumption patterns are the same all over the world
• It assumes that the basket of goods and services in the CPI is the same in all countries
• PPP does not take into account the transportation cost
• In real world, the forex market does not take into account the concept of purchasing power parity. PPP theory explains how the exchange rate should behave, but this concept does not explain the actual behavior of the forex market.
Theories behind Purchasing Power Parity
Law of One Price: This states that the price of an internationally traded good should be the same anywhere in the world, once the price is expressed in a common currency. If this does not hold true then people would be able to make profit by transporting goods from locations where the price is low to locations where price is high. The technique is called arbitraging.
Law of One Price: If an aggregate price level is ...