Purchasing power parity means that the exchange rate between two currencies is determined by the ratio of their purchasing power per unit currency.
Purchasing power parity, also known as purchasing power level.
Function introduction
Purchasing power parity exchange rate is used to compare living standards between different countries. The current currency exchange rate will mislead people to compare the living standards of people in different countries. For example, if the Mexican peso depreciates by half relative to the US dollar, the GDP in US dollars will also be halved. However, this does not mean that Mexicans have become poor. If the income and price level in pesos remain unchanged, and imported goods are not important to Mexicans' living standards (because the prices of imported goods will double), then currency depreciation will not bring about the deterioration of Mexicans' quality of life. This problem can be avoided if purchasing power parity is adopted.
A simple and humorous example of measuring purchasing power parity is the Big Mac index. This indicator is world-famous for its use of The Economist magazine. The Economist magazine compared the prices of Big Mac hamburgers sold by McDonald's branches in different countries. If the price of a Big Mac is $4 in the United States and ￡ 3 in Britain, then the purchasing power parity exchange rate between the dollar and the pound is ￡ 3 = $4. If in this example, the exchange rate between the dollar and the pound is 4 to 3.
basic thought
Purchasing power parity theory was first put forward by Swedish economist gustav cassel in the early 20th century. Simply put, purchasing power parity is the comprehensive price ratio between countries, that is, the price ratio when two or more currencies buy the same quantity and quality of goods and services in different countries, which is used to measure the differences in price levels between comparative countries. For example, if you buy a basket of goods with the same quantity and quality, 80 yuan RMB will be used in China and US$ 20 will be used in the United States. For this basket of goods, the purchasing power parity of RMB against USD is 4: 1, that is to say, the purchasing power of RMB in 4 yuan is equivalent to 1 USD of these goods. Purchasing power parity is essentially a special spatial price index, which is different from the consumer price index (CPl) that compares the price levels of two countries in a certain period. Therefore, using purchasing power parity as a currency conversion coefficient can meet the requirements of three conditions for international comparison of GDP.
the law of one price
Law of one price (cycle)
1, the premise of law of one price
Commodities located in different regions are homogeneous; The price of this commodity can be adjusted flexibly, and there is no price stickiness;
2. law of one price's conclusion
Goods within a country can be divided into two categories: one is tradable goods, which can be eliminated by arbitrage; One is non-tradable goods, because the goods themselves are immobile or the transaction cost of arbitrage activities is too high, so it is impossible to eliminate the price difference between regions through arbitrage activities. If the transaction cost and other factors are not considered, the price of the same tradable goods is the same everywhere. This relationship between the prices of tradable goods in different regions is called "law of one price".
3. law of one price in an open economy.
Under the open condition, the price comparison of tradable goods in different countries must be converted into a unified currency; Arbitrage activities, in addition to selling goods, also produced corresponding trading activities in the foreign exchange market; There are many special obstacles in transnational arbitrage activities, such as tariff and non-tariff barriers.
If transaction costs are not considered, law of one price in an open economy means that the prices of tradable goods measured in the same currency in different countries should be the same: Pi=ePi*
Absolute purchasing power parity theory
1, provided
For any tradable goods, law of one price was established; In the compilation of the price index of the two countries, all kinds of tradable goods have equal weight.
2, the basic form
The relationship between the two countries' tradeable commodity price levels: P=eP*
After deformation: e=P/P*
3. Significance
It means that the exchange rate depends on the ratio of the price level of tradable goods measured in different currencies, that is, on the ratio of the purchasing power of tradable goods measured in different currencies. In modern analysis, some scholars believe that there are various connections between a country's nontradable goods and tradable goods, so law of one price is also applicable to nontradable goods.
Relative purchasing power parity theory
1. Assume relaxation
Transaction costs exist;
When calculating the general price level of different countries, commodities and their corresponding weights are different. Therefore, the general price level in different countries is not completely equal when calculated in the same currency, but there is a certain stable deviation;
2. General formula
Derive the above formula and the rate of change,
3. Other forms
s(t+ 1)= s(t)[( 1+π)/ 1+π*]( 1)
=[s(t+ 1)-s(t)]/s(t) (2)
Substitute (1) into (2) to derive.
=(π-π*)/( 1+π*)
=π-π*
Theoretical test
Test of purchasing power parity theory
Purchasing power parity is generally not supported by empirical test. The reasons are as follows: There are technical difficulties in measuring and testing purchasing power parity:
Different choices of 1. price index will lead to different purchasing power parity, and it is still being debated which index is the most suitable.
2. Subjectivity in commodity classification will distort purchasing power parity, and it is difficult for different countries to achieve consistency and operability in commodity classification;
3. When calculating the relative purchasing power parity, it is difficult to accurately choose a base year when the exchange rate reaches or basically reaches equilibrium.
In the short term, the exchange rate will temporarily deviate from purchasing power parity for various reasons, such as price stickiness and capital and financial account transactions; In the long run, changes in real economic factors will permanently separate the nominal exchange rate from purchasing power parity, such as changes in productivity, changes in consumption preferences, discovery of natural resources and trade control.
The general conclusion of empirical research is:
(1) Since the floating exchange rate system was implemented in 1970s and 1980s, the real exchange rate has been highly correlated with the nominal exchange rate, and the real exchange rate has changed greatly.
(2) Generally, only in the period of high inflation (such as the 1920s) can PPP be well established.
(3) Deviations higher or lower than normal PPP often occur in a short period of time, and the deviation range is very large;
(4) In the long run, there is no obvious indication that PPP is established;
(5) The reality is that the change of exchange rate is far greater than the change of price.
Analysis and evaluation
Analysis and Evaluation of Purchasing Power Parity Theory
The theoretical basis of purchasing power parity is the theory of money quantity: the money supply determines the purchasing power of unit money, and the reciprocal of the purchasing power of money is the price level. Therefore, PPP believes that the amount of money determines the purchasing power and price level of money, thus determining the exchange rate. PPP is the representative of analyzing the exchange rate issue from the monetary level.
Purchasing power parity is the most influential exchange rate theory. This is because: 1, which analyzes the exchange of money from the perspective of its basic function (purchasing power), is clear in logic, easy to understand and the simplest in expression, and gives the simplest description of such a complicated issue as exchange rate determination; 2. A series of issues involved in purchasing power parity are very basic issues in exchange rate determination and are at the core of exchange rate theory; 3. Purchasing power parity (PPP) is widely used as the long-term equilibrium standard of exchange rate, and is also applied to the analysis of other exchange rate theories.
Many economists believe that PPP is not a complete exchange rate determination theory, and it does not clarify the causal relationship between exchange rate and price level.
defectiveness
Defects of purchasing power parity theory
1, ignoring the impact of international capital flows on the exchange rate. Although purchasing power parity theory has its irreplaceable advantages in revealing the fundamental reasons and trends of long-term changes in exchange rates, in the short and medium term, the impact of international capital flows on exchange rates is increasing;
2. Purchasing power parity ignores the factors of nontradable goods and the constraints of trade costs and trade barriers on international commodity arbitrage;
3. Many technical difficulties in calculating purchasing power parity limit its specific application.