Purchasing Power Parity
Summary
TLDRThis 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
💡 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.
🍕 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.
Mindmap
Keywords
💡Purchasing Power
💡Purchasing Power Parity (PPP)
💡Law of One Price
💡Absolute Purchasing Power Parity
💡Relative Purchasing Power Parity
💡Exchange Rate
💡Inflation
💡Non-Tradable Goods
💡Market Exchange Rates
💡GDP Comparison
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
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