Purchasing Power Parity theory (PPP) is a basis for economical comparability. However, can this really be true for just about any product at any time? Is purchasing electric power parity (PPP) only valid in the long run, or could it be also appropriate in the short run, and what about the type of the merchandise, i. e. tradable and non-tradable goods? Which limits are there to PPP?
Purchasing electric power parity attempts to explain why the real exchange rate between currencies is exactly what it is. It is based on the "law of 1 price" which suggests that in various markets, similar goods must have the same price. For goods which are easily traded, such as material and iron, prices should be equivalent within relevant range. The reason behind this is the fact if Ј100 could get you 10kg of flat iron in the local UK market, or 5kg in the overseas German market, one would expect people to buy iron in the united kingdom and sell it in Germany for a income, taken into consideration that transport costs are negligible, and that the flat iron is of comparative quality. Demand for UK flat iron would climb and demand for German iron would fall. Over time this would bring about prices for domestic UK iron to rise and for overseas German iron to show up. The equilibrium here would be that Ј100 could buy you 7. 5kg of UK iron, or 7. 5kg German iron.
As the money used in the UK and Germany differs we need to understand how many British isles pound we need to be able to buy one Euro. If you want Ј15 to get a haircut in the united kingdom and you will need 10, 50 to buy the same amount (one haircut) in Germany, then your real exchange rate would be Ј1. 43 per found by the method:
This strength/purchasing power of 1 currency over another should be identical in the long run. Hence the name purchasing vitality parity. Rogoff argues that the difference between the actual forex rate and the PPP exchange rate is. .
PPP is only a theory as it can't be shown to be correct, but until it is not disproved it is seen as a valid assumption. It really is considered to be valid over time rather than the brief run, as people remember to realize and exploit profitable dissimilarities in markets which eventually causes an extended run market equilibrium. Michaely (1982) argues that the PPP, which originally came from Gustav Cassel, is "indeed a monetary approach analysis; particularly it assigns the willpower of the foreign-exchange rate to the money market alone, without allowing an explanatory role to the goods market and to goods prices. "
As the true exchange rates are affected by tradable goods as well as by services, different interest levels, speculators and investment, it is not the best method to compare the purchasing ability of different currencies. Comparing GDP (gross domestic product) can be carried out if PPP is used to compare currencies on the bases over a basket of goods.
We can identify goods and services in a container of goods into two categories: tradable goods and non tradable/domestic goods. That is decided after how easily transferred/traded a good is really as well as government plans such as bans, tariffs and quotas enforced to them. Tradable goods, (goods) that are of equal quality no matter where they are produced, will be traded at a value near the market exchange rate. Generally, any good that is easily transferred belongs into this category. Highly tradable goods are raw materials such as yellow metal, petrol, gas, oil and diamonds that have a high value. Non tradable goods that are produced and used by domestic consumers such as hairdressers, taxi costs, house rent, and literature are hard to get exported, so when overseas people are unlikely to find a hairdresser whose price can compensate the costs of travelling, or move residences just because it is cheaper than the existing one, the non tradable goods will be nearer to the PPP exchange rate rather than the actual market exchange rate.
Whether a good is tradable or non-tradable will not only be based upon how easily it could be transported. Books may be cheap in Germany and are often transported, yet there may be little demand in the united kingdom for German catalogs, because they are written in a different language. A similar can be said about packed food and laptop computers for certain countries which have different letters in their alphabet. Their PPP may be further from the true exchange rate, as they would behave like non tradable goods.
There are exceptions to the rule, such as expensive surgeries or health care which is often much cheaper in east European countries than in western Europe. But are these of equal quality? The difference in price is because of different skills, less equipment and less experience. Eventually, over time, we would expect prices of east European doctors to go up, but there it's still a huge enough price difference which is due to travel and quality difference.
As PPP is based on a basket of goods and services, this already excludes ones that are not recorded. Many of these goods are not tradable, and therefore are afflicted by the income level of these countries. However, there are goods in overseas countries that are purposely listed under international market price, in order to obtain a market share. For instance, the German car production Volkswagen produces automobiles in Germany and offers them in Poland for less than in Germany. Volkswagen does indeed this because people in Poland earn significantly less than in Germany, and they want to get a big market share. A few of these cars get re-imported into Germany to be sold under the home price. As Volkswagen cannot increase its price in Poland without getting rid of customers and market talk about, car traders in Germany will need to lower their prices to be able to eventually get to equilibrium.
Besides the evident limitation to PPP that products are not always homogeneous, there is also the challenge with "apparent" quality difference. A Product manufactured in England might be seen by superior quality to the very same product manufactured in China. Both products, even though they are simply equal, could have different equilibrium prices.
PPP can not work in the brief run, as people remember to take notice of opportunities to exploit dissimilarities in prices. It is only valid for highly tradable and valuable goods such as diamonds and yellow metal, as these prices. Antweiler says that brief run exchange rate movements are influenced by the news headlines, such as "announcements about interest changes, changes in the notion of the growth avenue of economic"(2009).
Pappell (1997) discusses that the difference between PPP and the real exchange rate can also depend on which country's currency we base it on. This may happen because of program changes or because governments are artificially interfering with the exchange rate to be able to increase growth. Generally, the lower the income level of an overall economy is, the further away the PPP is from the true exchange rate, and the greater an economy builds up, the deeper the PPP will be (RIETI 2003). A good example of this might be China and its domestic currency "Yuan" whose exchange rate does not reflect the actual purchasing ability of other currencies. In this manner they increase exports and also have huge economic growth. With a common currency for multiple countries such as the Euro, it is simpler to compare prices, as no calculations have to be made. The purchasing ability of the euro differs across different Euro-countries (destatis, 2009).
In theory, purchasing electric power parity theory is valid, yet it's program has many limitations. It is an accurate justification of why exchange rates change, but only for a certain container of goods. Raw materials such as metals, diamonds and real wood are easily exchanged and a global market equilibrium are available fast. These goods are traded close to the true exchange rate. Non tradable goods such as packed food are hard to trade and will be nearer to the PPP exchange rate. Whether goods are of equal quality makes is a solid limitation to if the chosen goods can really be likened. PPP is only a valid theory in the long run, as people remember to have to discover and exploit the purchase price differences. Which has a common money across multiple countries like the Euro, this reduces this greatly. Lastly federal intervention with rules, import taxes and tariffs have an effect on the PPP as it makes buying international products more costly.