Exchange Rates: Purchasing Power Parity - Online Tutor, Practice Problems & Exam Prep

Purchasing Power Parity (PPP) asserts that exchange rates adjust to equalize the purchasing power of different currencies. For instance, if $1 buys one Coke in the US and £1 buys one Coke in the UK, parity exists. However, if the price of a Coke rises to £2 in the UK while the exchange rate remains £1 to $1, purchasing power parity fails, creating profit opportunities through arbitrage. Real-world factors like non-tradable services, consumer preferences, and trade barriers can disrupt this equilibrium, complicating the application of PPP in practice.

Purchasing Power Parity

All right. Now, let's discuss the theory of Purchasing Power Parity. So Purchasing Power Parity, PPP, states that exchange rates will move to equalize the purchasing power in different currencies. This is basically saying that you should be able to buy the same amount of goods with an equal amount of money in different countries, right? So if you have $1 in the US, you should be able to buy the same amount of stuff as if you were to exchange that dollar for a foreign currency and buy stuff in that foreign country. That's the purchasing power parity. So let's go through an example here to see how it works.

Let's say the exchange rate, let's keep it simple, is £1 to $1, right? One Great British pound for $1 and the price of a Coke is $1 in the US and 1 pound in the UK. Well, we have purchasing power parity in this situation because of this. If we take the $1 in the US, we can buy 1 Coke, right? Now we take that $1 to the UK, and we exchange it for £1. Let me see if I can draw this little symbol, £1. That wasn't too bad and you can get 1 Coke, right? When you exchange it for 1 pound and then you get 1 Coke. So they have equal purchasing power, right? Regardless of where you are, that same dollar gets you the same amount of stuff.

Okay. Now let's change it up a little bit. Let's say the exchange rate stays the same, £1 for $1, but now the price of a Coke is $1 in the US, but £2 in the UK. Okay? So now the price has changed in the UK to £2 for the Coke, right? We don't have purchasing power parity here. They're going to be different because notice, you can take the $1 in the US and the price is $1 so you get 1 Coke. Now you go to the UK and you try and do the same thing. You take the $1 and you get one £1. And now you try and buy a Coke and they say, hey, a Coke is £2 here. I don't know what you're trying to do with this £1. So you only get half a Coke in the UK, right? Because you need £2 for a full Coke, you only get half a Coke. So they have different purchasing powers now, right? And this doesn't follow purchasing power parity. Above, we have purchasing power parity because 1 Coke, that $1 could get you a Coke regardless of where you are. Now that $1 doesn't go as far in the UK. So what would need to happen to the exchange rate for this to still have parity here?

Well, we would need to be able to get £2 per dollar, right? We would need to be able to get £2 for your $1 to keep purchasing power parity. Right? Because if we had been able to exchange £2, right? If we were able to take our $1 exchange it for £2, well, now that £2 can buy you 1 Coke, right? And we would have purchasing power parity again. So you could buy a Coke in the US for $1, trade the $1 for £2, and then buy 1 Coke in the UK, just like we saw there. So in that situation, now we have purchasing power parity in. Now, the dollar and the pound have equal purchasing power again and we have purchasing power parity in that situation. However, if the exchange rate does not adjust for the change in the price levels, if we don't see that exchange rate adjust, well then there's an opportunity for profit. Okay?

And this is what leads back to purchasing power parity. So let's look at this example. Let's go back to the situation where there's $1 equals $1 and the prices are £1 again. Right? So there's not purchasing power parity. You can't get as many Cokes in the UK with your dollar. So this is what you could do to make some quick easy profit. Easy peasy profit right here, okay? This is the value you're really getting out of this lesson right here is how are you going to make all this money out of purchasing power parity using arbitrage, alright? So let's check it out. You buy 1,000,000 Cokes for $1,000,000 in the US, right? Each Coke is $1. You go out and you buy 1,000,000 Cokes, okay? Now, you take those Cokes to the UK. Let's say there are no shipping costs. You just take those Cokes over to the UK and you sell those 1,000,000 Cokes for £2,000,000, right? Because the price is £2 over there. So you're going to get £2,000,000 Easy peasy, right? You take those £2,000,000 from the UK and you trade them at that exchange rate. £2,000,000 for dollars and you end up with $2,000,000 Just like that. You started with $1,000,000 you ended with $2,000,000 Right? So that's the whole thing with purchasing power parity is if these exchange rates don't line up, there exists this possibility for profit. Of course, there would be some shipping costs, but the idea still remains there in theory, right? So as many people attempt this scheme, people start to see this value scheme here and they all start to buy the dollars to buy the Cokes and do this scheme right here, well they would bid up the price of the dollar, right? Because everyone's trying to buy dollars to buy the Cokes at this dollar and we would end up back at purchasing power parity eventually, right? This would increase and increase all the way up until we reach the equilibrium exchange rate which would be that £2 per dollar. And then, we would have purchasing power parity again, okay? So that's the whole idea of purchasing power parity is that the value of goods that you should get should be the same regardless of where you are based on the amount of money you have. Alright? So let's pause here and let's talk about some of the issues with the purchasing power parity theory in the next video.

Criticisms of Purchasing Power Parity

So, purchasing power parity attempts to explain changes in exchange rates, why they go up and down to keep prices constant across countries. However, it's not a complete explanation of exchange rates because of real-world issues that we see. First, not all products can be traded internationally like doctor services. Right? You can't buy a US doctor visit from Great Britain or something, right? You can't just buy it from another country like that. They can't be bought in one country and sold in another. No. Doctor service is not traded internationally.

Second, there's consumer preferences. Maybe consumers like Coke more in one country than in another country, right? So, they may be willing to pay a higher price for a certain product in one country than in another country. And finally, barriers to trade. So, a barrier to trade would be something that's stopping trade from happening freely. An import quota, which is a government-mandated maximum. They say, "hey, you can't import a million Cokes here. There's only a law that says only 500,000 Cokes can come in per year, right?" So, there's this import quota that happens. Or a tariff, a tax imposed on imports. So, every time you try to import something, you have to pay a tax. And that impedes the free market, right? When you have to pay these taxes. Okay? So these issues come into play and they don't always allow purchasing power parity to exist in real-world application.

Alright? So that's about it here. Let's go ahead and pause, and we'll move on to the next video.

Here’s what students ask on this topic:

What is Purchasing Power Parity (PPP) and how does it work?

Purchasing Power Parity (PPP) is a theory in macroeconomics that suggests exchange rates adjust to equalize the purchasing power of different currencies. Essentially, it means that a basket of goods should cost the same in different countries when priced in a common currency. For example, if $1 buys one Coke in the US and £1 buys one Coke in the UK, then the exchange rate should be £1 to $1. If the price of a Coke rises to £2 in the UK while the exchange rate remains £1 to $1, PPP fails, creating opportunities for arbitrage. This theory helps explain long-term exchange rate movements but is often disrupted by real-world factors like non-tradable services, consumer preferences, and trade barriers.

What are the limitations of Purchasing Power Parity (PPP)?

While PPP is a useful theory, it has several limitations. First, not all goods and services are tradable internationally, such as healthcare services. Second, consumer preferences vary across countries, leading to different willingness to pay for the same goods. Third, trade barriers like tariffs and import quotas can prevent the free flow of goods, disrupting PPP. These factors mean that PPP often does not hold in the real world, making it an imperfect tool for predicting short-term exchange rate movements.

How does arbitrage work in the context of Purchasing Power Parity (PPP)?

Arbitrage in the context of PPP involves exploiting price differences between countries to make a profit. For example, if a Coke costs $1 in the US and £2 in the UK, but the exchange rate is £1 to $1, you could buy Cokes in the US and sell them in the UK. You'd buy 1,000,000 Cokes for $1,000,000 in the US, sell them for £2,000,000 in the UK, and then exchange the £2,000,000 back to $2,000,000, doubling your money. This process would continue until the exchange rate adjusts to restore PPP, eliminating the arbitrage opportunity.

Why doesn't Purchasing Power Parity (PPP) always hold in the real world?

PPP doesn't always hold in the real world due to several factors. First, not all goods and services are tradable internationally, such as healthcare services. Second, consumer preferences vary, leading to different prices for the same goods in different countries. Third, trade barriers like tariffs and import quotas can prevent the free flow of goods, disrupting PPP. These factors create deviations from PPP, making it an imperfect predictor of exchange rates in the short term.

What role do consumer preferences play in Purchasing Power Parity (PPP)?

Consumer preferences significantly impact PPP. If consumers in one country prefer a product more than consumers in another country, they may be willing to pay a higher price for it. This difference in willingness to pay can lead to price disparities that disrupt PPP. For example, if people in the UK prefer Coke more than people in the US, they might be willing to pay £2 for a Coke while it costs only $1 in the US, even if the exchange rate is £1 to $1. This preference-driven price difference means PPP does not hold.