Purchasing power parity is the notion that a bundle of goods in one country should cost the same in another after exchange rates are considered.

There are two ways to express this concept:

1. Absolute Purchasing Power Parity
This concept posits that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept is derived from a basic idea known as the law of one price, which states that the real price of a good must be the same across all countries. To illustrate why this makes sense, suppose that soybeans are currently priced at $5 a bushel in the U.S., that soybeans are priced at ¬5.50 per bushel in Europe, and that the exchange rate is 1.10 euros per dollar. Suppose that the price of soybeans goes up to ¬6.05 per bushel (a 10% increase) in Europe, while the price of soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in the euro to offset the 5% difference, then European soybeans will not be competitive on the international market and trade flowing from the U.S. to Europe will greatly increase.

If we take weighted averages of prices for all goods within an economy, absolute purchase power parity maintains that the currency exchange rate between two countries should be identical to the ratio of the two countries' price levels.

This relationship can be expressed as:

Formula 5.5
S= P ÷ P*

Where Sis the spot exchange rate between two countries (the rate of the amount of foreign currency needed to trade for the domestic currency), P is the price index for a domestic country and P* is the price index for a foreign country. Note that the exchange rate used here is an indirect quote.

The following conditions must be met for this relationship to be true:
1.The goods of each country must be freely tradable on the international market.

2.The price index for each of the two countries must be comprised of the same basket of goods.

3.All of the prices need to be indexed to the same year.

Even if the law of one price holds for each individual good across countries, differences in weighting will cause absolute purchasing power parity. Determining comparable average national price levels is actually quite difficult and is rarely attempted. Analysts usually examine changes in price levels (indexes), which are easier to calculate; this gets around some of the problems of comparability.



Relative Purchasing Power Parity

Related Articles
  1. Investing

    Soybean, Corn Prices Slide After USDA Forecast

    Prices dropped after the U.S. Department of Agriculture reported higher-than-expected production forecasts for the current harvesting period.
  2. Investing

    Understanding Risk Parity

    Risk parity is an investment strategy that focuses on the allocation of risk across a portfolio.
  3. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  4. Trading

    Euro-Dollar Parity is Back

    With the euro hitting record lows against the dollar, market expectations are for euro-dollar parity in Q1, before the single currency finds support.
  5. Trading

    3 Ways To Forecast Currency Changes

    Forecasting exchange rates can help minimize risks and maximize returns. Here are three popular methods for forecasting exchange rates.
  6. Trading

    4 Ways To Forecast Currency Changes

    Whether you are a business or a trader, having an exchange rate forecast to guide your decisions helps to minimize risks and maximize returns.
  7. Trading

    Main Factors that Influence Exchange Rates

    The exchange rate is one of the most important determinants of a country's relative level of economic health and can impact your returns.
  8. Investing

    Grow Your Finances In The Grain Markets

    Hedging with futures can protect those who buy and sell commodities from adverse price movements.
  9. Investing

    La Nina Underpinning Soybean Rally (SOYB)

    Soybean futures have completed a basing pattern that could yield a powerful uptrend in coming months.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center