If a falling apple can teach Newton the law of gravity, the pricing of burgers can surely teach Johnny the law of purchasing power parity (PPP). But, the problem is that the foreign exchange market—the real testing ground for the law of PPP—is subject to many exceptions. So, unlike the law of gravity working on a falling apple, you may observe the law of “reverse gravity” working in the foreign exchange market. This is what makes the law stranger than the exceptions. It would be interesting to see what the law of PPP talks about.
Shailaja and Manoj K. Singh
Jinny: Hi Johnny! What are you doing next Sunday? If you are free, can we go shopping?
Johnny: Shopping? No way. I will not go shopping till I find out why our markets are so inefficient.
Jinny: What makes you think that our markets are inefficient?
Johnny: You may be aware about the principle of “one price”. It says that the same goods should trade at the same price in different markets. But, that’s hardly the case. You may not even find the same vegetables at the same price two blocks apart. What, then, to talk about goods selling in different countries.
Jinny: You should understand that the theory of one price could work only if we ignored local taxes and the cost of carrying goods from one market to another. Since ignoring taxes and carrying costs is only possible in theory, the law of one price also works only in theory. Anyway, this theory forms the basis for another interesting theory known as purchasing power parity (PPP). I hope you are aware of it.
Johnny: I would be happy if you would tell me about it.
Jinny: A Swedish economist, Gustav Cassel, developed the theory of PPP. This theory works on the assumption that our markets work on the law of one price. So, it assumes that identical goods and services must have the same price in different markets when measured in a common currency. If goods are not trading at the same price in two different currencies, then it means that the purchasing power of the two currencies is different. You can very well use the price of the same goods in different currencies compare their purchasing power. If a McDonald’s Big Mac burger is selling at $1 in the US, and at Rs20 in India, then it means that one dollar is worth 20 rupees in terms of purchasing power.
On the basis of the difference in the price of burgers, we can arrive at the PPP of different currencies. In fact, The Economist uses the price of the McDonald's Big Mac burger in different countries to arrive at its “Big Mac Index”, which gives the exchange rate of different currencies in terms of PPP.
Johnny: But people can’t live on burgers alone. What about other goods andservices?
Jinny: I was coming to that. To arrive at a realistic PPP of one currency against another, you need to carefully select a comparable basket of goods and services consumed in different countries.
Getting a haircut in India may be cheaper than in the US. So you can truly assess the purchasing power of the Indian rupee against the US dollar only when you compare a wider variety of goods and services. But, the goods and services that you compare must be of the same quality. You can’t compare a haircut in a deluxe salon in the US with a haircut by a roadside barber’s shop in India.
In fact, choosing a comparable basket of goods and services is the most challenging task in arriving at the PPP of different currencies.
Once you have a basket of comparable goods and services in hand, you need to just compare the difference in prices in terms of different currencies to arrive at the value of PPP.
Johnny: I was wondering why there is a disparity in the value of currencies in terms of PPP and the value of currencies in terms of their market exchange rate...
Jinny: Theoretically speaking, the value of currencies in terms of their market exchange rate should converge with their value in terms of PPP, in the long run. But that may not happen due to many reasons. For instance, some countries follow a fixed exchange rate system, which keeps the exchange rate at a fixed level. Some follow the managed float system, in which the central bank constantly tries to keep the exchange rate within a band. Even in countries where the free float system prevails, the market exchange rate may not converge with the PPP rate owing to many reasons.
As you know, the law of one price hardly works in many instances, making the calculation of the true value of PPP difficult. Our basic assumption, that the difference in price is due to the difference in purchasing power, may itself be only partially true. Who knows, pizzas may be selling at a higher price in India due to the higher digestive power of Indians. So, you may see lots of exceptions.
Johnny: Yeah. That’s what we call the law of reverse gravity in action.
What: Determination of the exchange rate of two currencies on the basis of their purchasing power parity (PPP).
Who: Swedish economist Gustav Cassel developed the theory of PPP.
How: This theory compares the price of the same goods and services in different currencies to calculate the PPP exchange rateof the currencies.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org