application areas

The concept of purchasing power parity is used for a number of applications:

• As a long-term exchange rate theory ( purchasing power parity theory ): Accordingly, exchange rates or inflation adjust so that purchasing power parity prevails between the two currency areas. The exchange rate at which purchasing power is the same in both currency areas is called the purchasing power parity exchange rate;
• As a correction factor: In order to make economic variables such as gross domestic product , gross national income , per capita income or absolute poverty internationally comparable, a mere conversion using current exchange rates is not sufficient, since purchasing power can vary greatly in different currency areas. Typical concepts here are the purchasing power standard ( PPS ) and the PPP US dollar ( PPP $). Here, however, no statement is made about economic strength, but rather the level of activity and the level of prosperity of the national economies compared, since the values ​​calculated using PPS are fictitious. Purchasing power parity theory Basic concept The purchasing power parity theory states that the exchange rates between two currencies fluctuate mainly to compensate for price level differences. It is based on the principle of the law of the single price . Accordingly, a good should sell for the same price all over the world. Otherwise there would be arbitrage opportunities . According to this theory, a monetary unit must have the same purchasing power in all countries , it must have the same real value everywhere. This is also called absolute purchasing power parity . The purchasing power parity theory originally stems from monetary foreign trade theory . It is calculated how many units of the respective currency are necessary to buy the same representative basket of goods that one could get for 1 US dollar in the USA. In the short term, the exchange rate can deviate from purchasing power parity, especially since monetary disruptions can cause rapid changes in the exchange rate, while the price level changes relatively slowly. In the long term, however, it should fluctuate around this value. This is then called relative purchasing power parity . Gustav Cassel is considered to be the pioneer of the purchasing power parity theory , although approaches to it can already be found in the 17th century. Based on this interpretation and the interest parity theory , Rudiger Dornbusch developed the monetary exchange rate theory . criticism The purchasing power parity theory is a simplified representation of the principle of how exchange rates are constituted. It does not include the transaction costs actually incurred in practice (transport costs, customs and tax duties, as well as distortions due to government trade restrictions). Since the theory is based on Jevons law , the same conditions must apply. However, this rarely occurs in reality. Dornbusch and Fischer show empirically, using the example of the exchange rate of the DM and the US dollar since 1979, that the theory cannot be applied linearly in every case. Another point of criticism is the (minor) influence that the buying and selling of foreign currency from commodity transactions have on exchange rate developments today. According to the latest foreign exchange statistics from the Bank for International Settlements in April 2007, the average daily turnover in the foreign exchange market is 3,210,000,000,000 (3.21 trillion) US dollars, an increase of 70% since the last survey in 2004. According to this, only about three percent of sales come from goods transactions. Purchasing power parities as a correction factor For international income comparisons, international organizations (e.g. World Bank ) determine such purchasing power parities empirically in order to eliminate distortions due to exchange rate fluctuations. The World Bank uses the term local purchasing power for its definition of poverty. In order to be able to compare people's incomes , the purchasing power of the US dollar is converted into local purchasing power. Since many developing countries have undervalued currencies (according to the purchasing power parity theory), their per capita income in (USD) purchasing power parities is mostly higher than converted using official exchange rates. A popular example of purchasing power parities on an alternative basis is the Big Mac index , published regularly by The Economist magazine . It determines how much a Big Mac costs in a McDonald’s restaurant in different countries around the world. These prices are made the basis of a currency conversion. The iPod index is similar. The sales price of the iPod produced by Apple is compared in different countries. A main difference between the two indices is that iPods represent a commodity that can be traded across national borders, while Big Macs do not trade internationally, which is why Big Macs cannot lead to offsetting arbitrage deals. The UBS compares some years Big Mac, bread, iPhones and more. However, it is not only focused on the price, but rather shows how many hours employees have to work in different cities and countries in order to be able to afford product X. Purchasing power comparison based on EuroStat data in the time series GDP per capita in purchasing power standards (EU28 as 100) country 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 1. EU (28 countries) 100 100 100 100 100 100 100 100 100 100 100 100 100 2. EU (27 countries) 100 100 100 100 100 100 100 100 100 100 100 100 100 3. Euro area (19 countries) 109 109 109 109 108 108 107 107 107 106 106 106 106 5. Euro area (18 countries) 110 110 109 109 108 108 108 107 107 107 107 107 106 6th Belgium 119 117 115 118 120 120 121 120 119 118 118 117 115 7th Bulgaria 37 40 43 43 44 45 46 46 47 47 49 49 50 8th. Czech Republic 79 82 84 85 83 83 82 84 86 87 88 89 90 9. Denmark 125 123 125 125 129 128 127 128 128 127 124 125 126 10. Germany 116 117 117 117 120 123 124 124 126 124 124 123 123 11. Estonia 64 69 69 64 65 71 74 75 76 75 75 77 81 12. Ireland 148 148 134 129 130 130 132 132 137 181 183 184 187 13. Greece 96 93 93 94 85 75 72 72 72 69 68 67 68 14th Spain 103 103 101 101 96 93 91 89 90 91 92 92 91 15th France 109 108 106 108 108 108 107 108 107 105 104 104 104 16. Croatia 58 61 63 62 59 60 60 60 59 59 60 61 63 17th Italy 108 107 106 106 104 104 102 98 96 95 97 96 95 18th Cyprus 101 104 105 105 100 96 91 84 81 82 83 84 87 19th Latvia 53 57 59 52 53 57 60 62 63 64 65 67 70 20th Lithuania 55 60 63 56 60 66 70 73 75 75 75 78 81 21st Luxembourg 261 265 262 255 257 265 260 261 270 267 257 253 254 22nd Hungary 61 60 63 64 65 66 66 67 68 68 67 68 70 23. Malta 78 79 79 81 84 83 84 85 88 93 94 96 98 24. Netherlands 136 138 139 137 134 133 133 134 130 129 128 128 129 25th Austria 126 125 125 127 126 128 132 131 130 130 127 128 127 26th Poland 51 53 55 59 62 65 67 67 67 68 68 70 71 27. Portugal 83 81 81 82 82 77 75 77 77 77 77 77 76 28. Romania 39 44 51 51 51 52 54 54 55 56 58 63 64 29 Slovenia 86 87 90 85 83 83 82 82 82 82 83 85 87 30th Slovakia 63 67 71 71 74 75 76 77 77 77 77 77 78 31. Finland 115 119 121 117 116 117 115 113 111 109 109 109 110 32. Sweden 125 128 127 123 125 126 127 125 124 125 123 122 121 33. United Kingdom 116 112 110 107 108 106 107 108 109 108 108 105 104 34. Iceland 130 129 129 128 116 114 116 117 119 124 128 130 133 35. Liechtenstein :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A :n / A 36. Norway 181 177 187 172 174 179 186 184 176 160 148 150 150 37. Switzerland 150 157 159 160 159 162 164 165 165 165 161 158 157 38. Montenegro 35 39 41 40 41 42 39 41 41 42 45 46 47 39. Macedonia 29 30th 32 34 34 34 34 35 36 36 37 37 38 40. Albania 22nd 23 25th 27 29 29 30th 29 30th 29 29 29 31 41. Serbia 32 33 36 37 36 37 37 38 37 36 37 37 40 42. Turkey 46 47 48 48 52 56 58 61 64 65 64 65 65 43. Bosnia and Herzegovina 26th 28 29 30th 29 30th 30th 30th 30th 30th 31 32 31 44. United States 155 152 146 146 145 143 146 145 146 147 145 145 143 45. Japan 111 109 105 103 105 103 106 107 104 106 107 105 98 Source: EuroStat, data from June 1, 2018. Example table for arbitrage possibilities based on example values Gross domestic products of selected countries from 1997 country GDP / capita (in USD) GDP / capita (in PPP-$) relation
Switzerland 43,060 26,580 0.62
United States 29,080 29,080 1

In 1997, about 1.43 Swiss francs had to be paid for one US dollar . 1.43 divided by 0.62 (see table) gives 2.31; the purchasing power parity between the dollar and the franc was accordingly 2.31. This means that in the year in question in Switzerland, at 2.31 francs, the same amount of goods could be purchased as in the USA with 1 US dollar.

According to the purchasing power parity theory, the Swiss franc would be overvalued against the US dollar because there would be an arbitrage opportunity. You could exchange francs for dollars so that you could buy goods in the USA and sell them at a profit in Switzerland. As a result, francs would be constantly exchanged for dollars, and the franc would lose value. Only if the Swiss franc had depreciated against the US dollar to 62% of its original value would this possibility no longer exist and arbitrage would no longer be worthwhile.

Empiricism

International Comparison Program

The World Bank's research program, originally initiated by Irving Kravis , Alan Heston, and Robert Summers , compares economies using purchasing power parity theory.

The international comparison project (ICP) tries to make the economic performance of national economies more comparable. A real comparison is often difficult as the freely formed exchange rates are often distorted (e.g. China's foreign exchange interventions). Therefore, the ICP considers the price development of shopping baskets according to the purchasing power parity approach in order to enable a more realistic investigation.

Price system choice & Samuelson effect

The choice of a suitable price system proves to be difficult, because despite the same economic performance - due to different price levels - countries appear to be performing differently. This distortion effect is also called the Balassa-Samuelson effect . The ICP chooses an average price system to reduce the Gerschenkrone effect.

model

The international prices ( average price system ) are defined as:

${\ displaystyle \ pi _ {i} = \ sum _ {j = 1} ^ {m} {\ frac {p_ {ij}} {KKP_ {j}}} \ cdot {\ frac {q_ {ij}} { Q_ {i}}}}$

Conversely, this results in the purchasing power parity of country j:

${\ displaystyle KKP_ {j} = {\ frac {\ sum _ {i = 1} ^ {m} p_ {ij} \ cdot q_ {ij}} {\ sum _ {i = 1} ^ {m} \ pi _ {i} \ cdot q_ {ij}}}}$

Explanation of the symbols:

• ${\ displaystyle \ pi _ {i}}$- international price for good i
• ${\ displaystyle p_ {ij}}$- Price for good i in country j
• ${\ displaystyle KKP_ {j}}$ - purchasing power parity of country j
• ${\ displaystyle q_ {ij}}$- amount of good i produced in country j
• ${\ displaystyle Q_ {i} = \ sum _ {j = 1} ^ {m} q_ {ij}}$ - World production of goods i

Results

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Compared to the conventional calculation using exchange rates:

• The gap between the countries is smaller
• Service quota (expenditure on services based on national product) is similar in developing and industrialized countries (approx. 1/3 each)
• The investment rate (investment expenditure measured against the national product) is much higher in industrialized countries

Criticism & Problems

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• statistical data collection
• Find a comparable product in order to be able to collect and collect (especially difficult for services)${\ displaystyle p_ {ij}}$${\ displaystyle q_ {ij}}$
• Gerschenkron effect occurs despite the average price system
• In the equation for determining international prices, a country's share of world production is heavily weighted:${\ displaystyle {\ frac {q_ {ij}} {\ sum _ {j = 1} ^ {m} q_ {ij}}}}$
• ⇒ Distortion of international prices in favor of countries with a higher share of global production
• ICP is based on the purchasing power parity approach, which presupposes free trade (law of the uniform price). However, this is only the case between some nations.

literature

• Reinhard Gerhold: Purchasing power parity as a link between real and monetary foreign trade theory , Metropolis , Marburg 1999.
• Maurice Obstfeld , Kenneth S. Rogoff : Foundations of international macroeconomics , 7th edition, Cambridge / MA 2004.
• Nicholas Mankiw : Fundamentals of Economics , 3rd edition Schäffer Poeschel, 2004.
• Irving B. Kravis: Comparative Studies of National Incomes and Prices, Journal of Economic Literature , American Economic Association, Volume 22 (1), pp. 1-39; March 1984.