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May 18, 2022
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Purchasing Power Parity
by Kathy Lien

The purchasing power parity theory is based on the belief that foreign exchange rates should be determined by the relative prices of a similar basket of goods between two countries. Any change in a nation’s inflation rate should be balanced by an opposite change in that nation’s exchange rate. Therefore, according to this theory, when a country’s prices are rising due to inflation, that country’s exchange rate should depreciate in order to return to parity.

PPP’s Basket of Goods

The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by gross domestic product (GDP). It includes consumer goods and services, government services, consumer items include food, beverages, tobacco, clothing, footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishings, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, good and services for personal care and household operation, and repair and maintenance services.

Big Mac Index

One of the most famous examples of PPP is the Economist’s Big Mac Index. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere, comparing these with actual rates signals if a currency is under- or overvalued. For example, in April 2002 the exchange rate between the United States and Canada as 1.57. In the United States a Big Mac cost $2.49. In Canada, a Big Mac cost $3.33 in local Canadian dollars (CAD), which works out to only $2.12 in US dollars. Therefore, the exchange rate for USD/CAD is overvalued by 15 percent using this theory and should be only $1.34.

OECD Purchasing Power Parity Index

A more formal index is put out by the Organization for Economic Cooperation and Development. Under a joint OECD-Eurostat PPP program, the OECD and Eurostat share the responsibility for calculating PPPs. The latest information on which currencies are under- or overvalued against the US dollar can be found on the OECD’s website. The OECD publishes a table that shows the price levels for the major industrialized countries. Each column states the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case the representative basket costs 100 units in the country whose currency is specified. The chart that is then created compares the PPP of a currency with its actual exchange rate. The chart is updated weekly to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the OECD; however, they should not be taken as definitive. Different methods of calculation will arrive at different PPP rates.

According to the OECD information for September 2002, the exchange rate between the United States and Canada was 1.58 while the price level for the United States versus Canada was 122, which translates to an exchange rate of 1.22. Using this PPP model, the USD/CAD was once again greatly overvalued (by over 25 percent, not that far away from the Big Mac Index after all).

Limitations to Using Purchasing Power Parity

PPP theory should be used only for long-term fundamental analysis. The economic forces behind PPP will eventually equalize the purchasing power of currencies. However, this can take many years. A time horizon of 5 to 10 years is typical.

PPP’s major weakness is that it assumes goods can be traded easily, without regard to such things as tariffs, quotas, or taxes. For example, when the United States announces new tariffs on imports, the cost of domestic manufactured good goes up; but those increases will not be reflected in the US PPP tables.

There are other factors that must also be considered when weighing PPP: inflation, interest rate differentials, economic releases/reports, asset markets, trade flows, and political developments. Indeed PPP is just one of several theories traders should use when determining exchange rates.

 
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