# FX Theory: Purchasing Power Parity

In this chapter we explain the Purchasing Power Parity (PPP), in particular the most relevant version of it, the PPP based on producer price indices (PPP-PPI), the one that reflects productivity of local firms. It is shown that the commodity currencies AUD, NZD and NOK were strongly overvalued in September 2012 but the Swiss franc was not.

## The theoretical basis

In this section we show the theoretical basis like tradable goods, the law of one price, the Penn and the Balassa-Samuelson effect.

### Law of one price

This law requests that in an efficient market, all identical goods must have only one price.

### The “Penn Effect” effect

Tradable goods cannot have large price variations between locations as buyers can obtain them form the location with the lowest price. But the majority of services must be delivered at the local level. Also many goods that have been manufactured have high costs associated with transport. The Penn Effect most often happens in the same direction: high incomes mean the average price will generally be high.

This implies that in order to compare the fair value of currencies only tradable goods should be considered.

### The Balassa–Samuelson effect

This economic model assumes that productivity or productivity growth-rates will differ more in a country’s traded good’s sectors that other sectors (Balassa-Samuelson hypothesis).

This implies that:

• Workers in some countries generate greater productivity than those in other countries and this acts as the source of income differences.
• For some labor-intensive jobs productivity innovations will have smaller effects. No matter their education or location a burger flipper will manage the same number of burgers/hour.
• Fixed-productivity sectors produce goods that cannot be transported (e.g. haircuts, the hairdresser has to be able to physically touch the hair to cut it).
• For local wages to be equalized the same job might be worth more in one location than another
• The CPI contains local goods (will be more expensive in rich countries) and tradables (same price in all countries).
• PPP (purchasing power parity) is used to peg the exchange rate for tradable goods (this is testable). See the law of one price above.
• Money exchange rates vary related to productivity of tradable goods (more than average productivity); and, for real goods the differential is less than for money.
• Productivity becomes income, meaning real income is not affected by changes in money as much.
• This is like stating that real income can be exaggerated by money exchange rates. Alternatively, items will cost more in richer countries.

For other theories why productivity plays a strong role in valuing currencies see our page on theories of the comparative advantage in international trade and the Neo Factor Proportion Theory.

## Absolute purchasing power parity measures

Absolute measurements compare a product like the Big Mac, which is nearly equal everywhere, and its price among different countries. Various Swiss export organizations continue to use these values in order to claim that the franc is overvalued. According to the Balassa–Samuelson effect they must compare tradable goods. A Big Mac produced in Switzerland cannot be sold in another country.

Big Mac and Starbucks Tall Latte Index

for details and critique please refer to our subpage on Big Mac and Starbucks Tall Latte index

for details and critique please refer to our subpage on the OECD Purchasing Power Parity Index.

Typically poorer countries have a basket with a higher weight for food and other consumption goods, but richer states give them a smaller weight.

Absolute measures for Purchasing Power Parity (PPP) have different major defects:

• These indexes include both tradable and non-tradable goods. Non-tradable goods must be more expensive in richer countries, because they are not exposed to global competition. Therefore, the difference between poorer and richer countries is accentuated.
• They use a single product as comparison basis for all countries. A non-tradable good, especially locally produced food is not useful, given that quotas or taxes might exist.
• Or they use standardized consumption basket (e.g. the OECD basket) with the same weights per category applied to all countries, even if the consumption basket in a richer country is different.

## Relative purchasing power parity measures

Relative measures compare prices changes for different countries between today and a base year (for example last year).

According to WikiWealth the PPP is the same as the Inflation Rate Parity:

Inflation Rate Parity (relative purchase price parity): Inflation decreases the value of money over time; whereas, investors seek to increase the value of their money over time. The currencies of low relative inflation countries will increase in value as demand for their currency increases.

WikiWealth uses inflation rate parity to have another indication of currency value. It helps to show the loss of value to currencies with high inflation rates. If one country had a significantly higher inflation rate than the target country, money would flow from the high inflation rate country to the low inflation rate country. WikiWealth uses the global weighted average to calculate expect returns, because investors are likely to search for a wide sample of countries for investment returns. Since inflation rates change quickly, and sometimes in unexpected ways, WikiWealth makes an adjustment to the inflation rate. The adjustment changes inflation rates over a span of five years from the current inflation rate to the long-term inflation rate.

Countries with higher interest rates typically need them to control inflation, which destroys value and potential over time. The net potential of the inflation rate parity approach is much less, because low inflation (good for investors) usually matches countries with low interest rates (bad for investors).

According to Investopedia the PPP is:

An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.

The relative version of PPP is calculated as:

Where:
“S” represents exchange rate of currency 1 to currency 2,
“P1” represents the cost of good “x” in currency 1 and
“P2” represents the cost of good “x” in currency 2

### The difference between PPP and Inflation Rate Parity

For us the relation between PPP and inflation rate parity is the following:

A country which is able to continuously provide a better price/quality relationship for their tradable goods than another country has a competitive advantage, it has a higher productivity. This competitive advantage is translated into a higher exchange rate that makes their products more expensive on the global market again (i.e. PPP via producer prices). The higher exchange rate leads to cheaper imported products and via cheaper imported prime materials to cheaper production (Partial Canceling Out of FX Effects).

Cheaper imports reduce inflation, especially in small open economies with a high import share. This directly leads to the Inflation Rate Parity.

Reasons for this competitive advantage can be found in cheaper tax levels, better infrastructure, more availability of (human) capital (see more in chapter 11) and lower debt and risk.

### Differences between PPP based on producer and consumer prices

The movement of PPPs with the time can be measured based on the producer price index abbreviated as PPP-PPI, or in consumer price indices abbreviated as PPP-CPI. Moreover one could use the GDP deflator or potentially an absolute measure like OECD index. Since the CPI or GDP deflator includes services (e.g. hair cutting), the best PPP measure for tradable goods is the one for PPP-PPI.

The formula shows that the “relative price” of currencies with low increases in production costs/prices (1+PPI term) must appreciate with the time:

$FX(year:n,&space;ccy1,&space;ccy2))&space;=&space;FX(year:0,&space;ccy1,&space;ccy2))&space;*&space;prod_{i=1..n}*&space;\frac{(1+PPI&space;_{ccy1,i})}{(1+&space;PPI&space;_{ccy2,i})}$

On the second page we speak about an application of the purchasing power parity theory.

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