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.