Purchasing power parity is a theory that says prices of goods between countries should equalize over time. Formula, how to use, and examples.
After the war, the Swedish economist Gustav Cassel suggested multiplying each currency’s pre-war value by its inflation rate to get the new parity. That formed the basis for today’s PPP. ❧
Annotated on January 30, 2020 at 12:29PM
Why We Don’t Live in a PPP World
PPP depends on the law of one price. That states that once the difference in exchange rates is accounted for, then everything would cost the same.
That’s not true in the real world for four reasons. First, there are differences in transportation costs, taxes, and tariffs. These costs will raise prices in a country. Countries with many trade agreements will have lower prices because they have fewer tariffs. Socialist countries will have higher costs because they have more taxes.
A second reason is that some things, like real estate and haircuts, can’t be shipped. Only ultra-wealthy global travelers can compare the prices of homes in New York to those in London.
A third reason is that not everyone has the same access to international trade. For example, someone in rural China can’t compare the prices of oxen sold throughout the world. But Amazon and other online retailers are providing more real purchasing power parity to even rural dwellers.
A fourth reason is that import costs are subject to exchange rate fluctuations. For example, when the U.S. dollar weakens, then Americans pay more for imports. ❧
Annotated on January 30, 2020 at 12:31PM