DEFINITION: a measure of the equilibrium value of a currency; the rate that will equate the cost of purchasing the same basket of goods in two countries.
USE: Some economists use the concept of purchasing power parity (PPP), to help predict long-run movements, in the foreign exchange value of a currency.
EXAMPLE: Consider the basket of goods and services purchased by the typical consumer in both countries. Assume that it can be bought in Europe with 100.00 Euros, whereas one needs $160.00 to buy it in the US. The market exchange rate is 1 Euro to $1.47. One may argue that the dollar is overvalued and will tend to depreciate (or equivalently that the euro is undervalued and will tend to appreciate). An American could go to the foreign exchange market and purchase 100.00 Euros with only $147.00 and buy the same basket of goods and services in Europe for which she would need $160.00 to buy in the US. THe theory suggests that in such a case US imports of goods and services will rise. But, as more dollars will be offered in the foreign exchange market to buy the necessary euros, the dollar will be pushed down (the euros up), until the dollar falls (the euro rises) to 1 Euro = $1.60.
HOWEVER: PPP may be helpful, to forecast the long-run value of a currency, but its usefulness to predict short-run variations is very strongly doubted. Not only will it take a long time for the equilibrium value as defined to be reached, but, in addition, there are many other economic forces that may keep the value away from equilibrium.
COMPLICATIONS:
The basket of goods in both countries may differ significantly.
The basket of goods and services bought by the typical consumer generally includes non-traded goods. If, given the market exchange rate, real estate is cheaper in the 'other' country, we cannot import buildings and houses from it.
Trade barriers and transport costs do exist, so many goods and services cannot be imported freely.
MOST IMPORTANTLY, exchange rates are highly influenced by capital flows and thus by interest rate differentials and changes in expectations.
Very useful as a conversion factor. PPP are better than market exchange rates, when comparing a single currency (generally to the US dollar) to GDP and per capita GDP figures. It incorporates the cost-of-living differences that will make cross-country comparisons of these variables more meaningful.
DEFINITION: a measure of the equilibrium value of a currency; the rate that will equate the cost of purchasing the same basket of goods in two countries.
USE: Some economists use the concept of purchasing power parity (PPP), to help predict long-run movements, in the foreign exchange value of a currency.
EXAMPLE: Consider the basket of goods and services purchased by the typical consumer in both countries. Assume that it can be bought in Europe with 100.00 Euros, whereas one needs $160.00 to buy it in the US. The market exchange rate is 1 Euro to $1.47. One may argue that the dollar is overvalued and will tend to depreciate (or equivalently that the euro is undervalued and will tend to appreciate). An American could go to the foreign exchange market and purchase 100.00 Euros with only $147.00 and buy the same basket of goods and services in Europe for which she would need $160.00 to buy in the US. THe theory suggests that in such a case US imports of goods and services will rise. But, as more dollars will be offered in the foreign exchange market to buy the necessary euros, the dollar will be pushed down (the euros up), until the dollar falls (the euro rises) to 1 Euro = $1.60.
HOWEVER: PPP may be helpful, to forecast the long-run value of a currency, but its usefulness to predict short-run variations is very strongly doubted. Not only will it take a long time for the equilibrium value as defined to be reached, but, in addition, there are many other economic forces that may keep the value away from equilibrium.
COMPLICATIONS: