Purchasing power parity and comparing competitiveness

Overview

Purchasing power parity.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is purchasing power parity?

   Model answer

   Purchasing power parity is the proposition that exchange rates should adjust so that a given basket of goods and services costs the same amount when expressed in a common currency, wherever it is bought. It rests on the idea that if a good were persistently cheaper in one country, buyers would purchase it there, and the resulting demand for that country's currency and goods would push the price or the exchange rate up until the difference disappeared. It provides a benchmark exchange rate reflecting relative price levels rather than capital flows.

2. 2

   What is the difference between absolute and relative purchasing power parity?

   Model answer

   Absolute purchasing power parity states that the exchange rate should equal the ratio of the price levels in the two countries, so that an identical basket costs the same everywhere in a common currency. Relative purchasing power parity is weaker and more realistic: it states that the rate of change of the exchange rate should equal the difference between the two countries' inflation rates, so that a country with higher inflation sees its currency depreciate by the difference. Relative parity can hold even where absolute parity does not, because a constant price gap does not violate it.

3. 3

   A basket of goods costs 80 pounds in the United Kingdom and 100 dollars in the United States. Calculate the purchasing power parity exchange rate.

   Model answer

   The parity rate is the ratio of the two prices, that is 100 dollars divided by 80 pounds, which is 1.25 dollars per pound. At this rate the basket costs the same in both countries when expressed in either currency, since 80 pounds multiplied by 1.25 equals 100 dollars.

4. 4

   A basket costs 80 pounds in the United Kingdom and 100 dollars in the United States, while the market exchange rate is 1.40 dollars per pound. Calculate the extent of any misalignment and state its direction.

   Model answer

   The parity rate is 100 divided by 80, which is 1.25 dollars per pound. The market rate of 1.40 is above this, so sterling is overvalued relative to purchasing power parity. The extent is 1.40 minus 1.25, which is 0.15, divided by 1.25, giving 0.12, so sterling is 12 per cent overvalued. In practical terms the basket costs 80 pounds in Britain but 100 divided by 1.40, which is 71.43 pounds, in America.

5. 5

   A standard item costs 3.60 pounds in the United Kingdom and 5.40 dollars in the United States, and the market rate is 1.25 dollars per pound. Calculate the implied purchasing power parity rate and say whether sterling is over or undervalued.

   Model answer

   The implied parity rate is 5.40 divided by 3.60, which is 1.50 dollars per pound. The market rate of 1.25 is below this, so sterling is undervalued against the dollar. The extent is 1.25 minus 1.50, which is minus 0.25, divided by 1.50, giving minus 0.1667, so sterling is about 16.7 per cent undervalued on this measure.

6. 6

   A basket of goods costs 600 yen in Japan and 4 pounds in the United Kingdom, while the market rate is 180 yen per pound. Calculate the parity rate and the misalignment.

   Model answer

   The parity rate is 600 yen divided by 4 pounds, which is 150 yen per pound. The market rate of 180 yen per pound is above it, so sterling is overvalued against the yen. The extent is 180 minus 150, which is 30, divided by 150, giving 0.20, so sterling is 20 per cent overvalued relative to purchasing power parity.

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