Understanding the meaning of purchasing power parity

There have been many attempts over the years to produce theories that allow the determination of 'correct' equilibrium values for FX exchange rates. This article is going to look at using the concept of purchasing power parity (PPP).

PPP was originally conceived as a means of gauging long-term equilibrium exchange rates between currencies. It is now, however, more commonly used as a tool for cross-country economic analysis, as we shall see.

What is purchasing power parity?

Purchasing power parity—often referred to simply by the acronym PPP—relies on a key assumption. It assumes a basket of goods in one country should cost the same as an identical basket in another country. This stems from the law of one price.

The law of one price states that any freely-traded goods will sell for the same price around the globe when the price is in a common currency.

Theoretically, the action of arbitrage should work to move prices so that they are consistent with the law of one price. Therefore, the theory assumes that transaction costs are equal everywhere.

In practice, transaction costs relate to the geographical location of buyer and product. Consequently, the law will only really work if we are able to exclude transportation costs, tariffs, taxes and other location-specific outlays.

Let's look at an example to better understand this theory. From there, we can extend the theory to come up with our PPP definition.

The law of one price: example

Let's compare the price of wheat in the US with its price in the UK to illustrate the theory.

Let's say that the price of wheat in the US is $4 per bushel. If GBP/USD is 1.2500, then—excluding transportation costs and so on—the price of one bushel of wheat in the UK should be 4/1.25 = £3.20. If the price diverges from this value, an arbitrage opportunity exists.

If wheat was, say, cheaper than £3.20 in the UK, what would this mean?

It would mean that traders could buy the wheat in the UK and sell it immediately at a higher equivalent cost in the US—all for a zero-risk profit.

Such trading action would serve to drive the price of wheat higher in the UK and lower in the US. This would continue until equilibrium was reached and prices in both countries obeyed the law of one price.

The law of one price is often confused with PPP but the two are subtly different.

So what does PPP mean?

The law of one price is specifically for the price of individual and identical goods or services. We define purchasing power parity by extending the law of one price to consider prices in aggregate.

The simplest form of the theory is absolute purchasing power parity.

Absolute PPP says that exchange rates are in equilibrium when the value of a national basket of goods and services are the same between two countries. The purchasing power parity theory predicts that market forces will cause the exchange rate to adjust when the prices of national baskets are not equal.

If we are comparing country A to country B, with an exchange rate E, the theory says:

Price of basket in country A = Price in basket in country B x E

We can then manipulate this purchasing power parity formula to give:

E = Price of basket in country A / Price of basket in country B

Therefore, the PPP exchange rate equals the ratio of a basket of goods in one country with an identical basket of goods in another. This will not hold unless the baskets are identical, however, and this is easier said than done. One particular problem is ensuring the weightings given to goods in each basket are the same.

It is often more convenient, therefore, to consider instead relative purchasing power parity, which does not require the same basket of goods in each country.

This is a double-edged sword. It makes relative PPP much easier to measure, but it also makes it a weaker version of PPP than the absolute version.

This is the relative purchasing power parity definition:

The exchange rate between two countries will adjust in response to a difference in the two national inflation rates.

To go into the specifics of the relative purchasing power parity equation is beyond the requirements of this discussion. Put simply, though, relative PPP suggests the exchange rate will change by a percentage that equals the difference in the inflation rates.

Simple relative purchasing power parity example

Let's say the inflation rate in the US is 2% and the inflation rate in the eurozone is zero. Relative purchasing power parity says the dollar should weaken against the euro by 2% each year.

In reality, we would not expect a strict adherence to this annual change in value. Instead we might expect to see some kind of conformance to PPP in the long-term average.

Importers and exporters should respond to differences in the relative costs of baskets of tradable goods in ways that, on average, should be consistent with the law of one price.

It follows that comparing exchange rates implied by PPP to market exchange rates might help us view a currency pair as overvalued or undervalued.

So does purchasing power parity actually hold true?

In short, the answer is not really, at least in the short or medium term.

Of course, you can gather your own empirical evidence to determine the effectiveness of the theory.

As a very rough exercise, I looked at the market rate for GBP/USD over a ten year-period. I then compared it with changes in the inflation rates.

Here's a monthly GBP/USD chart taken from MetaTrader 4:

I then looked at annual changes in the CPI rates for the US and the UK from 2005 to 2015.

The Bureau of Labor Statistics publishes this for the US and the Office for National Statistics provides the data for the UK.

Overlaid on the chart, the difference between the inflation rates looks like this:

In my eyes, there is some broad agreement there, but you may find it more convincing to do your own research beyond this quick and dirty version. Bear in mind the line drawn is just a visual aid for the scatter points rather than an actual representation of interpolated points.

An excellent way to experiment with real market data is to use our risk-free demo trading account.

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Of course, a large amount of empirical evidence has already been gathered on the subject.

In a research paper on PPP, the St Louis Fed noted that "after accounting for average levels of overvaluation and undervaluation, there is evidence of convergence toward PPP."

However, it's the divergence that we need to worry about, because it is significant.

Evidence suggests there is prolonged divergence from the theory for both absolute and relative PPP, meaning we need an explanation for why the theory fails.

To provide this explanation, we need to look at the disadvantages of PPP, of which there are more than few.

Disadvantages of purchasing power parity

In order to define PPP, we extended the law of one price. In other words, PPP is only going to hold up if the law of one price first holds true.

Unfortunately, it doesn't really stand up to scrutiny. You'll probably have observed yourself when filling up your car that prices at the pumps vary from city to city. So the law of one price doesn't even hold perfectly between markets in a single country.

Why is this?

It is because there are barriers to trade.

We do not operate in a world where there are zero transportation costs. Nor is price information perfectly and immediately available to all participants.

Therefore, there may be price discrepancies that are not inevitably whittled away by arbitrage. Taxes and tariffs are further examples of real-world barriers that hinder the international movement of goods.

More importantly, there is also the effect of non-traded costs. Some items will factor into price baskets but cannot be traded. Primarily, these are labour and land.

PPP also relies on markets being perfectly competitive. Companies pricing to market—charging more in countries with inelastic demand—will interfere with this.

Another drawback is the difficulty in compiling the data. Recording market-based exchange rates is extremely easy. To put together wide baskets of data for different countries is a huge job and the data is, therefore, only recorded infrequently.

FInally—even if we assume that PPP can provide a long-term benchmark guide to whether an FX rate is under or overvalued—its use may be limited by the timeframes involved. Most CFD traders are looking at timeframes of days and weeks rather than years.

So if PPP has limited utility in the real world as a predictor of exchange rates, why do we care about it?

One reason that people have been reluctant to discard the theory is that PPP is, at its core, very logical. It is one of few fundamental ways to try and determine if a currency is overvalued or undervalued.

More important than that, though, it is also an excellent tool for making like-for-like comparisons between countries.

Purchasing power parity theory and its role in international business

The most common application of PPP is as a way of comparing metrics such as wages and GDP across countries. When looking at GDP, PPP allows us to make a more apples-to-apples comparison that takes into account how the cost of living for each territory.

Let's say that we wanted to compare the GDP per capita between the UK and Mexico.

The quickest way would be to just take the spot rate for GBP/MXN and convert the Mexican GDP per capita—recorded and reported in Mexican pesos—into a figure in sterling.

This would give a slightly skewed result, though, because it does not take into account how far the money goes in each country. Also, if the market exchange rate fluctuates suddenly, it can make a big difference to such a comparison.

You might find that suddenly the GDP of one country appears to have grown relative to another, just because of a temporary blip in the market exchange rate.

What we can do instead is adjust for Mexico and UK purchasing power parity.

Purchasing power parity exchange rates allows us to compare living standards across countries. Furthermore, PPP rates are more stable over time than market-determined exchange rates. In fact, converting via PPP is a common method used by major economic bodies for comparing GDP, wages, etc.

The OECD and the IMF are just some of the well-known organisations that compile PPP index data.

For example, you can see that the IMF uses GDP based on PPP in its World Economic Outlook Database.

One of the more fun versions is the Big Mac Index, which The Economist has been publishing since 1986. Tongue-in-cheek and simplified it may be, but it is, nonetheless, still a valid—and widely-followed—purchasing power parity index.

What is the principle behind the Big Mac Index?

With some notable exceptions, the Big Mac tends be uniform throughout the globe. The same bits and pieces go into making a Big Mac in Wisconsin as they do in Leipzig in Germany, Thunder Bay in Canada or Melbourne in Australia.

It makes some sense, therefore, to use the famous burger as a proxy for a small basket of directly comparably goods. In other words, it is an easy and convenient means of comparing how much bang you get for your buck, euro, loonie or Australian dollar.

Summary: what is PPP?

A simple purchasing power parity definition is that it is an extension of the law of one price to accomodate prices for the whole economy.

The IMF defines it this way:

The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country.

Originally developed, as a theory for determining exchange rates, absolute PPP predicts that an exchange rate will adjust to equalise price levels.

Relative PPP suggests an exchange rate will eventually adjust to reflect differences in the respective inflation rates.

More commonly, PPP exchange rates are used for cross-country comparison of standards of living.

A PPP exchange rate is the ratio of prices for a basket of final goods in two countries.

Final thoughts on purchase power parity

We hope this article has given you an insight into what is the meaning of purchasing power parity.

It is a useful theoretical benchmark to consider for long-term equilibrium rates, but there is little evidence to suggest it is a useful predictive measure. It is more normally used by economists to compare standards of living between countries, rather than as a tool for trading FX.

If you are considering using fundamental analysis to inform your trading, PPP shouldn't be top of the list unless you are looking very long term. Even then, there are question marks over its direct usefulness. Of course, the vast majority of people using CFDs to trade FX tend to operate over short to medium time-frames.

That said, even if you mainly focussed on shorter trading durations, it is helpful to keep an eye on the overall long-term trend of the market. Any pointers in this area are worth bearing in mind.

If you are interested in reading more about other fundamental indicators, take a look at Best Forex Fundamental Indicators Explained.