Purchasing power parity

Purchasing power parity ( PPP or KKB = purchasing power adjusted; English purchasing power parity , PPP ; parity = equality from Latin par 'equal') is a term from macroeconomics . Purchasing power parity between two geographic areas in the same currency area exists when goods and services in a basket of goods can be purchased for the same amount of money. If two different currency areas are compared, the amounts of money are made comparable using exchange rates . In this case, purchasing power parity prevails if the different currencies have the same purchasing power due to the exchange rates and you can therefore buy the same shopping basket. If there is purchasing power parity between two countries, the real exchange rate is one. Purchasing Power Parity (PPP) is the macroeconomic counterpart to the microeconomic law of indifference in prices .

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 Switzerland	43,060	26,580	0.62
United States 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