Purchasing power parity

Purchasing power parity
Purchasing power parity
Anonim

Purchasing power parity is a theory proposed by Swedish economist Gustav Kassel. Although earlier similar ideas were mentioned by Ricardo D.

The essence of the theory

Purchasing power parity
Purchasing power parity

According to the law of supply and demand, goods that are traded between different countries should not be sold on the market at very different prices. This is necessary in order to avoid the vigorous activity of speculators, which ultimately leads to price equalization. That is, in the long run, the value of a good destined for international trade should be the same, excluding taxes and tariffs, and measured in the same currency. This law is called the term "purchasing power parity" (PPP).

PPP concept

According to the theory, the real exchange rate should remain constant in the future. Therefore, the parity of currencies always changes as much as necessary to compensate for the difference in the dynamics of price fluctuations in different countries. If the growth of inflation in a given country exceeds the growth of prices abroad, then the nominal currency will depreciate under equal conditions.

GDP at purchasing power parity
GDP at purchasing power parity

Cons of PPP theory

Purchasing power parity is not without its drawbacks. For example, price equalization across countries is difficult because not all services and goods provided are traded internationally. In addition, goods that are traded between countries are not interchangeable for some consumer groups. It is for this reason that GDP at purchasing power parity may actually fluctuate slightly, but its fluctuations will be temporary.

The ratio of real and nominal exchange rates

To think about the issue of exchange rates, consider this simple example. Suppose there is a situation where all countries are engaged in the production of one product, and all goods move freely between different countries. Of course, in this case there is no point in exchanging a domestic product for a similar foreign product, except in equal proportions one to one. Therefore, the real exchange rate will always be equal to one.

Purchasing power parity in the short run

Currency parity
Currency parity

The PPP theory works only in the long run, since it is impossible to trace the behavior of the exchange rate in a short period. The failure of PPPs can also be explained by the following reasons: for example, countries produce different groups of goods and services, and not similar ones, as the concept of the theory suggests. Or in the event that certain goods and services do not take part in international trade, and transportation costs and legal nuances prevent the equalization of prices for goods and services involved in the exchange between different countries. This means that purchasing power parity is not always strictly observed, but it is quite expected that the prices of goods will gradually converge. This theory generally works well for countries with high inflation rates, as the changes in relative inflation rates are generally much larger than the real changes in the exchange rate.

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