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

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