Purchasing Power Parity

Summary

This video explains the concept of Purchasing Power Parity (PPP), starting with purchasing power, which refers to how much goods and services one can buy with a set amount of money. It explores the law of one price, which suggests identical goods should cost the same across countries when currency values are adjusted. The video contrasts absolute and relative PPP, highlighting that the former doesn't hold due to trade barriers and costs, while the latter accounts for inflation rates between countries. PPP is valuable for comparing economic metrics like GDP across countries more accurately than market exchange rates.

Takeaways

• 💰 Purchasing power refers to how many goods and services can be bought with a specific amount of money.
• 📉 A decline in purchasing power occurs when you can buy fewer goods with the same amount of money.
• 🌍 The law of one price states that identical goods should cost the same in different countries when accounting for exchange rates.
• 💱 Purchasing Power Parity (PPP) suggests that two currencies should have the same purchasing power for the same goods in different countries.
• 🍕 Absolute PPP implies that the price of the same product in different countries should be equal when converted by exchange rates.
• 🚫 Absolute PPP doesn't always hold due to factors like non-tradable goods, transportation costs, trade restrictions, and imperfect information.
• 📈 Relative PPP takes inflation into account and explains changes in exchange rates based on differences in national price levels.
• 🔄 Inflation impacts exchange rates: when a country's prices rise, its currency tends to depreciate relative to others.
• 📊 PPP is often used for comparing GDP between countries more accurately than using market exchange rates.
• 🌐 Market exchange rates can be influenced by factors like government interventions and speculation, while PPP focuses on purchasing power.

Q & A

What is purchasing power?

Purchasing power refers to the amount of goods and services that can be bought with a certain amount of money. For example, if you could previously buy five chocolates with five euros but now can only buy four, your purchasing power has declined.

What is the law of one price?

The law of one price states that identical goods should have the same price in different countries when expressed in a common currency. This concept is key to understanding purchasing power parity (PPP).

How is absolute purchasing power parity (PPP) calculated?

Absolute PPP is calculated by finding the ratio between the prices of the same product in two countries. For example, if a pizza costs $3.80 in the U.S. and €3.45 in Italy, dividing these prices gives the exchange rate of 1 euro = 1.10 U.S. dollars.

What happens when prices of the same goods differ between countries?

If the price of a good is cheaper in one country, people from the higher-priced country might convert their currency and buy it from the cheaper country, driving up the demand for the cheaper country's currency and causing prices to equalize.

Why does absolute PPP not always hold in reality?

Absolute PPP does not always hold because of factors like non-tradable goods, transportation costs, trade restrictions, and imperfect information. These factors prevent prices from equalizing across countries.

What are non-tradable goods, and why do they affect PPP?

Non-tradable goods are services or products that cannot be easily exported or imported, such as public utilities, local transportation, and hotel accommodations. These goods prevent prices from equalizing across countries, affecting absolute PPP.

How does relative PPP differ from absolute PPP?

Relative PPP takes inflation into account and considers how changes in price levels affect exchange rates over time. It focuses on the relative changes in prices between two countries rather than assuming prices are equal everywhere.

How does inflation influence the exchange rate according to relative PPP?

Inflation causes a country’s currency to depreciate. If one country experiences inflation while another does not, the exchange rate will adjust to reflect the difference in inflation rates.

Why is PPP important for comparing GDP across countries?

PPP is important because it allows for a more accurate comparison of GDP between countries by eliminating biases caused by artificially manipulated exchange rates. It provides a clearer picture of the actual purchasing power of each country's economy.

What are some challenges in determining PPP rates?

Challenges in determining PPP rates include differences in purchasing habits, unequal quality of goods, and varying economic conditions in different countries. These factors can make it difficult to assess the true purchasing power between nations.

Outlines

00:00

💡 Understanding Purchasing Power and PPP

This paragraph introduces the concept of purchasing power, explaining it as the amount of goods and services that can be bought with a specific sum of money. It provides an example where the number of chocolates bought with the same amount of euros decreases, indicating a decline in purchasing power. The paragraph also introduces the law of one price, stating that an identical product should have the same price in different countries when converted into their respective currencies. Purchasing Power Parity (PPP) is based on this law and suggests that income should have the same purchasing power across countries.

05:01

🍕 Absolute Purchasing Power Parity (PPP) Explained

This section delves into absolute PPP, which asserts that identical products in different countries should have equal prices when converted into respective currencies. The paragraph uses a pizza price comparison between the U.S. and Italy to explain how exchange rates are calculated based on this idea. It applies PPP to Kosovo and Albania, where differences in candy prices would lead to exchange rate adjustments due to changes in demand. However, the absolute PPP rarely holds in reality due to various factors like non-tradable goods, transportation costs, taxes, and imperfect information.

Keywords

💡Purchasing Power

Purchasing power refers to the amount of goods and services that can be bought with a specific amount of money. In the video, it explains how if the price of chocolates rises, fewer chocolates can be bought with the same amount of money, indicating a decline in purchasing power. It is essential for understanding how currency values affect what people can buy in different countries.

💡Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through the concept of 'the law of one price.' It suggests that in the absence of transportation costs and other barriers, identical goods should have the same price when expressed in a common currency. PPP allows for a more accurate comparison of economic productivity and living standards between countries.

💡Law of One Price

The law of one price states that identical goods should have the same price in different countries when converted to a common currency. In the video, this principle is used to explain how purchasing power parity operates under the assumption that the same product, like a pizza, should cost the same in different countries once exchange rates are considered.

💡Absolute Purchasing Power Parity

Absolute PPP asserts that the price of an identical good in two different countries should be the same when accounting for exchange rates. For example, if a pizza costs $3.80 in the U.S. and €3.45 in Italy, dividing these prices gives the exchange rate. However, the video also explains that absolute PPP often does not hold due to factors like transportation costs and non-tradable goods.

💡Relative Purchasing Power Parity

Relative PPP accounts for inflation differences between two countries and examines how exchange rates change over time based on these inflation rates. The video illustrates this concept with an example where inflation in the U.S. increases by 5%, leading to a depreciation of the U.S. dollar relative to the euro.

💡Exchange Rate

An exchange rate is the value of one currency in terms of another. The video uses examples, like the exchange rate between the U.S. dollar and the euro, to demonstrate how PPP influences currency value and how these rates are calculated using the price ratios of identical goods in different countries.

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services rises, eroding the purchasing power of a currency. In the context of PPP, the video explains how inflation affects exchange rates. For instance, higher inflation in one country will cause its currency to depreciate relative to others.

💡Non-Tradable Goods

Non-tradable goods are products or services that cannot be easily exported or imported, such as water supply, public transportation, or hotel accommodations. The video explains that the existence of non-tradable goods is one reason why absolute PPP does not always hold, as these goods' prices can differ across countries.

💡Market Exchange Rates

Market exchange rates are the rates at which one currency can be exchanged for another based on supply and demand in the global market. The video contrasts market exchange rates with PPP rates, noting that market rates are influenced by factors like government intervention, speculation, and interest rates, making them more volatile than PPP rates.

💡GDP Comparison

Gross Domestic Product (GDP) is the total value of goods and services produced in a country. The video explains that PPP is often used to compare GDPs between countries because it adjusts for differences in currency value, providing a more accurate comparison of the real economic output of different nations.

Highlights

Purchasing power refers to the amount of goods and services you can buy with a certain amount of money.

The law of one price states that an identical good in one country should have the same price in another country when converted into different currencies.

Purchasing power parity (PPP) is based on the law of one price, where your income should have the same purchasing power in all countries.

Absolute PPP asserts that the same product in different countries should have the same price when expressed in a common currency.

To find the exchange rate using absolute PPP, divide the price of a product in one country by the price of the same product in another country.

When prices differ between countries, people might arbitrage by converting currencies and buying goods where they are cheaper.

Absolute PPP often fails due to factors like non-tradable goods, transportation costs, trade restrictions, and imperfect information.

Relative PPP takes inflation into account, linking exchange rate changes with differences in inflation between two countries.

Relative PPP is more accurate than absolute PPP because it accounts for inflationary changes in national price levels.

A depreciation in a currency occurs when there is inflation in a country, requiring more of that currency to purchase foreign goods.

Relative PPP is used to predict changes in exchange rates based on the inflation rate differences between countries.

PPP helps compare the purchasing power of different countries' currencies and provides more accurate measures than market exchange rates.

Market exchange rates can be influenced by factors like government interventions, speculation, and trading, making PPP more reliable for long-term comparisons.

PPP rates are relatively constant over the long run, while market exchange rates are more volatile.

PPP is useful for making accurate comparisons between countries' GDPs by eliminating biases from manipulated or artificially high exchange rates.

Transcripts

purchasing power parity in order to

understand what purchasing power parity

or PPP is let's first see what

purchasing power is purchasing power

simply means the amount of goods and

services you can buy with a certain

amount of money for instance it's before

you were able to buy five chocolates

with five euros but now with the same

five euros you can only buy four

chocolates

your purchasing power has declined the

second thing you need to know to

understand PPP is of all at one price it

pretty much says that one good in one

country should have the same price of an

identical good in another country when

converting into different currencies

therefore the purchasing power of two

currencies should be the same for the

identical products purchasing power

parity is based on the law of one price

in refers to situation where your income

has the same purchasing power in all

countries hence given that PPP holds and

all prices are equal a person should be

able to purchase what his/her income the

same basket of goods everywhere no

matter what currency he uses there are

two versions of purchasing power parity

one of absolute PPP and the other one is

relative PPP absolute PPP says that the

same product in different countries

should be equal so let's say that one

pizza in u.s. costs 3.8 zero dollars and

the same pizza in Italy costs 3.4 five

euros

according to the law of one price or

also known as the absolute peak impede

the purchasing power of two currency it

should be the same and the exchange rate

should be a matter of finding the ratio

of the two prices thus if you divide the

price of the pizza and us with the price

of the pizza in Italy we get the

exchange rate for US dollars and euros

this means that each euro is equal to

one point one zero dollars let's apply

the purchasing power parity to Kosovo

and Albania if ten candies and COS of a

cost two euros in the same ten candies

in Albania costs 260 left then the

exchange rate would be one euro equals

two 130 left 10 no matter what currency

we use the purchasing power is the same

in both countries but what happens when

prices of candies are not the same in

Kosovo and in Albania if the candies are

cheaper in Kosovo

some people come Albania would come to

Kosovo convert the Leki to euros in

order to buy the candies with cheaper

price this new demand for euros would

ride the value of the euro until average

prices of goods are the same in each

country when converted at the new

exchange rate but can we buy the same

amount of goods with our income

everywhere around the world does the

absolute PPP hold well actually it does

not here are some of the reasons why

absolute PPP does not hold non tradable

goods transportation cost and trade

restrictions and perfect information etc

as we said earlier when goods our traded

prices will become equal however there

are non tradable goods which cannot be

imported or exported so there are lots

of reasons for the prices to equalize

for instance you cannot trade the price

of publics

recessions water supply and local

transportation or the prices of hotel

accommodations the absolute purchasing

power parity makes the assumption that

taxes as most transportation costs do

not exist which is not true so because

of the different transportation costs

prices will be different also countries

have different tariffs and taxes that

prevent crises from equalizing across

countries the absolute purchasing power

parity also assumes perfect information

about what our goods prices and other

markets with perfect information one

would be able to export goods to the

market with the high price whereas

import goods form the market with a low

price however not everyone is informed

and hence prices are different since

absolute purchasing power parity does

not look at reality we now move on to

the relative purchasing power parity

relative PPP takes inflation into

account it does so by considering the

relationship between the changes of the

exchange rate and the changes of the

prices ratio note that the price levels

will increase if there is inflation

therefore the exchange rate is

determined by the difference in the

national price levels between the two

countries let's take an example let's

say that the current exchange rate is

one point one zero dollars per euro now

suppose that the inflation rate in u.s.

is predicted to be five percent in the

upcoming year while in Kosovo we predict

zero percent inflation rate what would

be the exchange rate in the upcoming

year if we expect a US prices to

increase by five percent we calculate

the following one point one zero US

dollars times 1.05 equals to one point

one five five US dollars per one euro

which is the new exchange rate now you

need more US dollars to get one Europe

therefore the US dollar is depreciating

while the euro is appreciating as a

result there is a reverse relationship

between the national price levels and

current

where there is inflation the value of

the currency depreciates and vice versa

what if we expect Kosovo's inflation to

be 3% in the upcoming year relative to

the prices in kosovo prices and new s

are rising at a rate of 2% so the new

exchange rate would be one point one

zero US dollars times one point zero to

an equal to one point one to two US

dollars for one euro therefore the

relative purchasing power parity

examines their relative changes in price

levels between two countries and

maintain that exchange rates will change

according to inflation so it is a better

measure than the absolute purchasing

power parity finally why do we need to

measure such as PPP we need PPP to

compare purchasing power of different

countries currency PPP currency rates

are considered more accurate than market

exchange rates market exchange rates

tend to be influenced by other factors

such as government interventions a

different interest rates speculation

trading and hedging on the other hand

PPP rates are often difficult to

determine because of differences in

purchasing habits among the citizens of

different countries unequal quality of

goods in those countries and differences

in each countries economies but once the

PPP rate is determined it remains

relatively constant over the long run

PPP is often used to make more accurate

comparison between two countries GDP

than can be made when using market

exchange rates for example let's look at

country a and Country beef where each of

them produces the same amount of goods

in a given year

thus the GDP should be the same for each

country but because country be

manipulated currency on the world market

its currency is artificially high when

compared to country as currently it

takes three countries dollars to buy one

country B's euro

so using the market exchange rates to

compare GDP it would look as country B's

GDP were three times the size of the

country's GDP when expressed in the same

currency using the PPP exchange rate it

would eliminate this bias and put

the GDP of each country is the same