Economic Issue of the Day
Philippine Institute for Development Studies S u r i a n s a m g a Pa g -a a ral Pangkaunlaran ng Pilipinas
Vo l . I X N o . 2 ( D e c e m b e r 2 0 0 9 )
Purchasing power parity (PPP): understanding the law of one price Defining and illustrating PPP If the costs of trade are ignored, one liter of Coca-Cola in Metro Manila should cost the same as one liter of Coke in Japan or anywhere in the world where Coca-Cola is sold and traded. This law of one price is the basis of the purchasing power parity (PPP) concept developed by Swedish economist Gustav Cassel in 1918. The law of one price suggests that under an ideal market set-up, the cost of identical goods or services must have the same price when converted into a common currency. Since the components of one liter of Coca-Cola are the same regardless of where it is produced, it should have the same price in Metro Manila as abroad. To date, the most common illustration of PPP is the Big Mac Index formulated by ‘The Economist.’ Table 1 indicates how the prices of McDonald’s Big Mac Burger across countries (which presumably has identical ingredients across countries) differ when converted in US dollars. The computed PPP exchange rate
is the local currency price of the Big Mac divided by the price in US dollar. For example, the PPP exchange for Argentina is 2.56 pesos per dollar. This is equal to 8.25 pesos—the cost of a Big Mac in that country—divided by 3.22 US dollars. The PPP exchange rate generated suggests what the trend of exchange rates should be if the costs of Big Mac are to approach the US price level of 3.22 US dollars. It indicates the number or amount of local currency needed ‘to purchase an amount of goods and services equivalent to what can be bought with one unit of currency of a base country’ (ADB 2005), which in this case, is the US dollar. The currency is undervalued if the PPP exchange rate value is lower than the official exchange rate, and overvalued if it is higher. For example, the official exchange rate of Argentina is 3.11 which suggests that its currency is slightly undervalued. Meanwhile, the Philippine peso, Thai baht, and Chinese yuan are deemed to be grossly undervalued based on this criterion.
Looking at the potential use(s) of PPP
Table 1. A feast of burgernomics: the Big Mac index Big Mac Prices in Local in Currency Dollars United Statesa Argentina Britain Canada China Philippines Saudi Arabia Singapore Thailand UAE
$3.22 Peso 8.25 £1.99 C$3.63 Yuan 11.0 Peso 85.0 Riyal 9.00 S$3.60 Baht 62.0 Dirhams 10.0
3.22 2.65 3.90 3.08 1.41 1.74 2.40 2.34 1.78 2.72
Implied Actual Dollar Under (-)/Over (+) PPP* of Exchange Rate Valuation against the Dollar Jan 31st the Dollar, %
2.56 1.62b 1.13 3.42 26.4 2.80 1.12 19.3 3.11
3.11 1.96b 1.18 7.77 48.9 3.75 1.54 34.7 3.67
Purchasing power parity: local price divided by price in United States. Average of New York, Atlanta, Chicago, and San Francisco. b Dollars per pound. Source: McDonald's; The Economist. * a
-18 +21 -4 -56 -46 -25 -27 -45 -15
Absolute PPP (or PPP in an ideal market set-up) extends this law of one price to general price levels (Hakkio 1992). After selecting and determining the prices of common or identical baskets of goods and services typically consumed between countries, these prices are then equated and equalized to the PPP exchange rates. PPP assumes exchange rate to be reflective of the overall price levels in each country (Hakkio 1992). More precisely, the sum of goods and services consumed or produced in an economy in a given year is valued or multiplied by their corresponding prices in US dollars. This conveys what is generally known as ‘GDP in PPP dollars’. The simplicity of the PPP has made it very popular among economists and academicians. Institutions like the World Bank and the International Monetary Fund (IMF) have also been
Economic Issue of the Day
PURCHASING POWER PARITY
Vo l . I X N o . 2 ( D e c e m b e r 2 0 0 9 )
known to estimate gross domestic product (GDP) levels using PPP to rank and compare the general outputs of their member countries. Since PPP uses a basket of goods and services commonly consumed by families across countries, it can effectively demonstrate the living standards and purchasing power of households, and the sizes of country economies as well. In the calculation of of PPP to estimate GDP levels and GDP per capita, market prices are used to determine the actual costs of the basket of goods. This means that taxes and inflation rates have already been incorporated in the generation of actual basket costs (Hakkio 1992). In view of this, GDP in PPP terms (and even GDP per capita) may differ markedly from the one converted to a common currency like the US dollar using the prevailing exchange rate. In a sense, this use of market prices in calculating actual costs is what makes the PPP a better alternative than the use of market exchange rate in comparing GDP levels to give the picture of an economy. At the same time, meanwhile, aside from its use for comparison, the PPP is also used by others as a measure of exchange rate or to predict trends in market exchange rates, thinking that these two will eventually meet up. While there is a certain appeal in thinking that actual market exchange rates would converge and equal their PPP values in the long run, in reality, however, this may never happen due to several factors. One, it is difficult to identify a set of goods and services that is identical and comparable across countries. People in different countries have differing consumption levels and patterns. For absolute PPP to hold, homogeneous or perfectly uniform goods must be determined and selected. And even if these were possible, chances are many of these goods will be calculated using imperfect price indices. The presence of transaction costs (i.e., shipping costs, tariff, insurance costs, etc.) and nontradable goods also contribute to the failure of PPP as a theory of exchange rate determination. Different countries impose different taxes, tariffs, and other transaction costs which can have distorting effects on the general price levels. Nontradable goods (like haircut services) cannot be traded and/or transported in other countries; hence, the prices
of these goods and services cannot compete fairly and cannot be compared effectively vis-à-vis an observed exchange rate (Hakkio 1992). In addition, some governments like China follow a fixed exchange rate system, and keep exchange rate at a certain level. Some adhere to a managed float exchange rate system where central banks try to keep the exchange rate within a band (Singh 2007) through interest rate manipulations, speculations, hedging, and the like. These interventions by the central banks can influence foreign exchange markets, thereby implying that fluctuations in exchange rates may not necessarily connote changes in the country’s overall economic performance. It is precisely this characteristic and tendency of the market exchange rate to be artificially manipulated that makes it illsuited as an indicator of economic well-being. Using market exchange rate to compare GDP levels can sometimes give a misleading picture of an economy. And this is where, as noted earlier, the use of the PPP provides an edge.
PPP as yet an imperfect tool Nonetheless, while the use of the PPP is indeed a significant improvement over that of the market exchange rate, particularly in intercountry comparisons, the method is still far from perfect. The presence, among others, of transaction costs and difficulty in determining the standard basket of goods, as shown above— issues raised against the PPP as a measure of exchange rate— are also the very same issues being hurled at it as an indicator of economic welfare. Perhaps this explains why despite the usefulness of the PPP in comparing GDP levels and GDP per capita, ‘it still cannot be used to establish strict rankings between countries' (ADB 2005). N
References Hakkio, C.S. 1992. Is purchasing power parity a useful guide to the dollar? Economic Review, 3rd Quarter. Federal Reserve Bank of Kansas City. Asian Development Bank (ADB). 2005. Key indicators. Manila. Singh, S. ‘What is purchasing power parity?’ http://www.livemint.com/ 2007/12/10015124/Ask-Mint—What-is-purchasing.html. [Accessed November 29, 2009].
The Economic Issue of the Day is one of a series of PIDS efforts to help in enlightening the public and other interested parties on the concepts behind certain economic issues. This dissemination outlet aims to define and explain, in simple and easy-to-understand terms, basic concepts as they relate to current and everyday economics-related matters. This Issue was written by Fatima Lourdes E. del Prado, Research Specialist at the Institute, with comments and suggestions from Dr. Josef T. Yap and Ms. Jennifer P.T. Liguton, President and Director at PIDS, respectively. The views expressed are those of the author and do not necessarily reflect those of PIDS and other member agencies and sponsors. N Philippine Institute for Development Studies NEDA sa Makati Building, 106 Amorsolo Street, Legaspi Village, Makati City z Telephone Nos: (63-2) 8942584 and (63-2) 8935705 z Fax Nos: (632) 8939589 and (63-2) 8161091 URL: http://www.pids.gov.ph