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What Is the Connection between Purchasing Power Parity and Exchange Rates?

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  • Written By: Jim B.
  • Edited By: Shereen Skola
  • Last Modified Date: 16 August 2018
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Purchasing power parity and exchange rates are inextricably linked together by the so-called law of one price, which states that goods should essentially cost the same no matter where they are purchased. This is the driving concept behind purchasing power parity, or PPP, which shows the relationship between countries in terms of their purchasing power. When a certain product costs more in one country than it does in another, PPP implies that the disparity should be equal to the difference in exchange rates between the currencies of the two countries. Should that not be the case, it represents a buying opportunity for consumers, which will eventually drive prices back toward the equilibrium of purchasing power parity.

For countries that have different currencies, exchange rates are established for the differences in values between those currencies. According to the law of one price, however, products should essentially cost the same everywhere and countries should have equal purchasing power. This contradiction is explained by the relationship between purchasing power parity and exchange rates.

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As an example of how the concepts of purchasing power parity and exchange rates work, imagine that four units of currency in Country A equal one unit of currency in Country B, meaning that the countries have an exchange rate of four-to-one. In country B, a certain product costs 25 units of currency. According to PPP, that product should cost 100 units of currency in Country A. This is because the ratio of four-to-one is equal to the ratio of 100-to-25.

Using this same example, imagine that the product is priced at only 95 units of currency in Country A. This means that consumers would get a value by shopping in Country A. It also means that, according to the laws of economics, the demand for the product in Country A will grow, causing manufacturers of the product in that country to ramp up production. Since more production means higher costs, the firms in charge of production will raise the product's price, until it eventually reaches the equilibrium implied by PPP.

In this way, purchasing power parity and exchange rates essentially work in tandem. It is important to note that these concepts will only work in harmony if the countries in question have competitive markets. If a government controls economic forces in a country, or if there is a monopoly by a single firm over production of certain goods, purchasing power parity is likely to be thrown askew when compared to exchange rates.

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wander
Post 2

@Sara007 - I have found from my travels that purchasing power parity isn't really affected by individuals coming into the market. While a price may stay steady in relation to what is being charged nationwide, it also can work out to some amazing deals from those coming from abroad.

Favorable exchange rates can make it possible to get high-end electronics at steep discounts, and while that may seem like something that couldn't possibly continue, the fact is, visitors just don't buy enough to encourage the increased production that purchasing power parity seems to see as a definite. Though, that is fine by me, as I grab my deals while I can.

Sara007
Post 1

When my husband and I were in Australia we noticed the prices of consumer goods were much higher than those in North America. At first glance it might appear that Australians are getting ripped off, but they actually aren't because they have a high minimum wage. However, they also pay a lot of high taxes so this appears to be a case of all-around inflation.

I think this kind of thing needs to be taken into account when considering purchasing power parity: the model doesn't carry over perfectly from country to country because even when the dollar amounts are comparable, the inflation the local citizenry is dealing with may not.

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