PPP (Purchasing Power Parity) Exchange Rates

Summary

The video explains the concept of Purchasing Power Parity (PPP) and its relationship to exchange rates. PPP theory asserts that exchange rates should reflect the relative costs of goods and services in different countries. By comparing baskets of goods, the video shows how the value of currencies can be determined based on their ability to purchase the same level of goods across countries. The video explores how changes in inflation, wages, and currency values affect exchange rates and the real exchange rate, using the Big Mac Index as a practical example of PPP in real-world currency comparisons.

Takeaways

• 😀 Purchasing Power Parity (PPP) theory suggests that exchange rates should reflect the cost of a basket of goods and services in different countries.
• 😀 A basket of goods in the UK costs £1,000, while in the US it costs $1,600. The exchange rate between the UK and the US is 1:1.60, which reflects purchasing power parity.
• 😀 When exchange rates align with PPP, you can buy the same amount of goods in one country as you could in another after converting currencies.
• 😀 If the price of the US basket of goods increases to $1,700, but the exchange rate remains at 1:1.60, the exchange rate no longer reflects PPP, as the pound is now undervalued.
• 😀 Nominal exchange rates can fail to reflect true purchasing power, leading to currencies being over or undervalued.
• 😀 The real exchange rate, which accounts for price changes, is a better measure for reflecting purchasing power parity between currencies.
• 😀 In theory, if a currency is undervalued, it should adjust to reflect PPP through changes in trade and demand, but this self-adjustment doesn't always happen in reality.
• 😀 Speculative flows, rather than trade effects, often drive exchange rate values, meaning currencies can remain overvalued or undervalued due to speculation.
• 😀 Economists use tools like the Big Mac Index to assess whether currencies are over or undervalued based on the price of a Big Mac in different countries.
• 😀 The Big Mac Index compares the price of a Big Mac in different countries. If the price is higher in one country, that currency is considered overvalued; if lower, it's undervalued.
• 😀 The Big Mac Index uses a simplified version of PPP, focusing on a single product, to determine the relative value of currencies based on their purchasing power.

Q & A

What is the main concept behind purchasing power parity (PPP)?

Purchasing power parity (PPP) suggests that the exchange rate between two currencies should reflect the relative price of a basket of goods and services in both countries. Essentially, the same basket should cost the same amount in both countries when converted to the respective currencies.

How is PPP theory applied to exchange rate theory?

PPP theory is applied to exchange rates by asserting that the value of one currency relative to another should enable the purchase of the same basket of goods in both countries. If exchange rates deviate from this, one currency is considered overvalued or undervalued.

Can you explain the example of purchasing power parity between the UK and the US in the script?

In the example, a UK basket of goods worth £1,000 is equivalent to $1,600 in the US, with a floating exchange rate of 1 GBP = 1.60 USD. This exchange rate reflects PPP since the goods in both countries cost the same when converted, maintaining purchasing power parity.

What happens when the price of the US basket increases to $1,700?

If the US basket increases to $1,700 while the exchange rate remains at 1 GBP = 1.60 USD, the exchange rate no longer reflects PPP. The UK’s £1,000 can no longer purchase the same level of goods and services in the US, indicating that the pound is undervalued relative to the dollar.

What is the difference between nominal and real exchange rates in the context of PPP?

The nominal exchange rate is the current market rate without adjusting for price changes. The real exchange rate, however, adjusts for differences in price levels between countries, offering a more accurate measure of purchasing power parity.

How should exchange rates adjust according to economic theory when a currency is undervalued or overvalued?

According to economic theory, exchange rates should self-adjust in floating systems. If one currency is undervalued, its demand should increase as people buy goods in that country, which would lead to an appreciation of the undervalued currency, thus restoring PPP.

Why don't exchange rates always self-adjust in the real world as economic theory suggests?

In reality, exchange rates are influenced more by speculative flows than by trade effects. Speculation can prevent currencies from adjusting to reflect PPP, causing currencies to remain undervalued or overvalued for extended periods.

What is the Big Mac Index and how does it relate to PPP?

The Big Mac Index is an informal measure of PPP that compares the price of a Big Mac in various countries to its price in the US. It simplifies the concept of PPP by using the Big Mac as a 'basket' of goods, revealing whether a currency is overvalued or undervalued based on its price relative to the US price.

What did the Big Mac Index reveal about the Swiss Franc and the Chinese Yuan?

According to the Big Mac Index, the Swiss Franc is overvalued as its price of a Big Mac in Switzerland is much higher than in the US. Conversely, the Chinese Yuan is undervalued because the price of a Big Mac in China is much lower than in the US, indicating that the Yuan can purchase more in China than the US dollar can.

Why is the Big Mac Index a useful tool for economists?

The Big Mac Index is a simple and accessible way to measure whether currencies are overvalued or undervalued. It provides a clear comparison of the purchasing power of different currencies based on the cost of a standardized product across various countries.