We introduced the concept of purchasing power parity in Chapter 4 when we discussed economic development. This concept is also useful in determining at what level an exchange rate should be. Recall that purchasing power parity (PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Thus, although the law of one price holds for single products, PPP is meaningful only when applied to a basket of goods. Let’s look at an example to see why this is so.
Suppose 650 baht in Thailand will buy a bag of groceries that costs $30 in the United States. What do these two numbers tell us about the economic conditions of people in Thailand as compared with people in the United States? First, they help us compare the purchasing power of a Thai consumer with that of a consumer in the United States. But the question is: Are Thai consumers better off or worse off than their counterparts in the United States? To address this question, suppose the GNP per capita of each country is as follows:
Thai GNP/capita = 122,277 baht
U.S. GNP/capita = 26,980 dollars
Suppose also the exchange rate between the two currencies is 41.45 baht = 1 dollar. With this figure, we can translate 122,277 baht into dollars: 122,277 ÷ 41.45 = $2,950. We can now restate our question: Do prices in Thailand enable a Thai consumer with $2,950 to buy more or less than a consumer in the United States with $26,980?
We already know that 650 baht will buy in Thailand what $30 will buy in the United States. Thus we calculate 650 ÷ 30 = 21.67 baht per dollar. Note that whereas the exchange rate on currency markets is 41.45 baht/$, the purchasing power parity rate of the baht is 21.67/$. Let’s now use this figure to calculate a different comparative rate between the two currencies. We can now recalculate Thailand’s GNP per capita at PPP as follows: 122,277 ÷ 21.67 = 5,643. Thai consumers on average are not nearly as affluent as their counterparts in the United States. But when we consider the goods and services that they can purchase with their baht—not the amount of U.S. dollars that they can buy—we see that a GNP per capita at PPP of $5,643 more accurately portrays the real purchasing power of Thai consumers.
Our new calculation considers price levels in adjusting the relative values of the two currencies. In the context of exchange rates, the principle of purchasing power parity can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels. In other words, PPP tells us that a consumer in Thailand needs 21.67 units (not 41.45) of Thai currency to buy the same amount of products as a consumer in the United States can buy with one dollar.
As we can see in this example, the exchange rate at PPP (21.67/$) is normally different from the actual exchange rate in financial markets (41.45/$). Economic forces, says PPP theory, will push the actual market exchange rate toward that determined by purchasing power parity. If they do not, arbitrage opportunities will arise. Purchasing power parity holds for internationally traded products that are not restricted by trade barriers and that entail few or no transportation costs. To earn a profit, arbitrageurs must be certain that the basket of goods purchased in the low-cost country would still be lower-priced in the high-cost country after adding transportation costs, tariffs, taxes, and so forth. Let’s now see what impact inflation and interest rates have on exchange rates and purchasing power parity.