In this video we’ll look at purchasing power parity and analyse the implications of purchasing
power differentials.
Purchasing power parity is a method used to adjust exchange rates for the differences
in purchasing power between different countries.
Since the same goods and services have different prices around the world, purchasing power
will differ from the simple conversion of the exchange rate.
In a moment we will look at a sample market basket in the US and then we will compare
it to the same market basket in Canada using the given exchange rate.
Before continuing, you should note that in this video, the dollar symbol by itself will
represent the US dollar.
When you see the letter “C” preceding the dollar symbol it is a reference to the
Canadian dollar.
In the United States, this market basket of goods costs about $10 USD.
1 soda, 1 ice cream and one loaf of bread together cost 10 USD.
How much do these identical products cost in Canada?
Well in Canada, the same market basket of goods costs about $12.80.
We’ll need the nominal exchange rate to answer the following question.
Does the purchasing power parity match the exchange rate?
We will use the exchange rate from December 12th 2020 where 1 USD is equal to 1.28 Canadian
dollars.
If this market basket costs $10 in the US, it should cost $12.80 in Canada.
Since it does, the PPP exchange rate is the same as the nominal exchange rate.
What would happen if purchasing power differed in between two countries?
To simplify, we will only consider one good, specifically a can of Coca-Cola, as representative
of the prices in the US and Canadian economies.
Given our previous exchange rate of 1 USD to 1.28 Canadian dollars, we can see in this
table that a Coca-Cola is twice as expensive in Canada as it is in the US.
Let’s break this information down further.
For every $1.28 CAD the Canadians exchange, they will receive 1 United States dollar.
Adjusting for the value of the Canadian dollar to the US dollar, 1 Canadian dollar equals
0.78 US dollars.
If a Canadian exchanges 2.56 Canadian dollars, they will receive 2 US dollars.
This will allow Canadians to purchase 2 cans of Coca-Cola in the United States.
Instead of using $256 CAD to purchase 100 cans of Coca-Cola in Canada, they should travel
to the US, covert to $200 USD and purchase 200 cans of Coca-Cola.
Essentially, one can of Canadian Coca-Cola is equivalent to two cans of US Coca-Cola.
The real exchange rate between the two countries is equal to 2 cans of US Coca-Cola per can
of Canadian Coca-Cola (OR) 0.5 cans of Canadian Coca-Cola per can of US Coca-Cola.
In currency terms, this means the real exchange rate should be 1 US dollar to 2.56 Canadian
dollars.
Since the nominal exchange rate is 1.28 Canadian dollars to 1 US dollar, the real exchange
rate of 2.56 Canadian dollars to 1 US dollar suggests that the Canadian currency is overvalued
and should depreciate to reach its true value.
If these price differentials occurred across all goods, Canadians would purchase more US
imports and likely sell fewer exports to the US.
This movement of currency would increase the demand for US dollars and also increase the
supply of Canadian dollars.
This would result in a depreciation of the Canadian dollar and an appreciation of the
US dollar as they moved toward parity.
Let’s use the same countries again, but this time we will cut the price of a Canadian
can of Coca-Cola to 64 Canadian cents.
Given our nominal exchange rate of 1 USD to 1.28 Canadian dollars, we can see in this
table that a Coca-Cola is half the price in Canada relative to the US.
For every $1 USD the US Americans exchange, they will receive $1.28 CAD.
At the given prices, this will allow US Americans to purchase 2 cans of Coca-Cola ($0.64 CAD
x 2).
Instead of using $100 USD to purchase 100 cans of Coca-Cola in the US, they should travel
to Canada, convert to $128 CAD and purchase 200 cans of Coca-Cola there.
Essentially, one can of Canadian Coca-Cola is equivalent to a half can of US Coca-Cola.
The real exchange rate equals 0.5 cans of US Coca-Cola per can of Canadian Coca-Cola
(OR) 2 cans of Canadian Coca-Cola per can of US Coca-Cola.
In currency terms, this means that the real exchange rate should be $1 USD = $0.64 CAD.
If the current exchange rate is 1.28 Canadian dollar to 1 US dollar and the real exchange
rate is actually 0.64 Canadian dollars to 1 US dollar, this situation suggests that
the Canadian currency is undervalued and should appreciate to reach its true value.
If these price differentials occurred across all goods, Canadians would purchase less US
imports and likely sell more exports to the US.
This movement of currency would increase the demand for Canadian dollars and also increase
the supply of US dollars.
This would result in an appreciation of the Canadian dollar and a depreciation of the
US dollar as they moved toward parity.
In reality, exchange rates do not reach purchasing power parity.
They may move towards it in the long-run, but in the short-run they can fluctuate significantly
with respect to parity.
There are additional limitations of purchasing power parity theory to consider as well.
Finding perfectly comparable market baskets across countries is difficult.
To find identical goods that are produced to an identical quality is nearly impossible
when comparing a large basket of goods and services in two countries.
Second, nominal exchange rates do not automatically adjust to changes in PPP due to restrictions
on imports and exports.
Not every good can be easily and cheaply transported from one country to another.
There are trade restrictions and import and export controls that limit how easily goods
can move.
Beyond this, tariffs can offset cost savings that importing can generate.
Thirdly, you cannot export certain services like haircuts or domestic care.
Finally and this was mentioned earlier, transport costs are a significant factor in moving goods
from one country to another.
Even in the absence of trade barriers, you are still required to transport goods to take
advantage of price differentials.
This can result in significant transportation costs that will reduce the benefit of purchasing
goods in the relatively cheaper country.
By now you should have a much clearer understanding of purchasing power parity and its implications
for exchange rates.
If you have any questions or comments, leave them below and let’s try to address them
together.
That’s us done for now and I will see you in the next one!