This website uses cookies to ensure you have the best experience. Learn more

Purchasing Power Parity Essay

3237 words - 13 pages

December 12, 2005

Vikram Sharma

Note on Purchasing Power Parity
When someone from a developed country is considering taking a job in a developing country, she may have to consider a number of factors and salary is one of them. Let us assume that the given person has two job offers, one in the United States with an annual salary of $60,000 and another in India with everything else the same but with an annual salary of Rs. 2000,000 (approximately equivalent1 to $43,375 based on nominal exchange rate). Let us assume, everything else which is important for the person is exactly the same in both jobs and the person intends to spend all the salary on lifestyle goods2. On a pure dollar face ...view middle of the document...

Market exchange rates fluctuate widely, and the purchasing power parity hypothesis suggests that in the long run the market exchange rates and PPP rates should converge4. This note provides a primer on PPP and is divided into three sections. The first section describes and compares different methods for PPP exchange rate estimation. The second section discusses the drivers for the difference in the nominal and PPP rates. The third and final section provides some applications and examples of PPP. _______________________
1 2

Based on an exchange ratio of US$ 1 = 46.11, access from www.x-rates.com on December 11, 2005 Lifestyle goods here includes living expenses, food, beverages and entertainment 3 As determined by nominal US Dollar/Indian Rupee exchange rate 4 Lawrence H. Officer, “Purchasing Power Parity and Exchange rates: Therory, Evidence and Relevance”, Jai Press Inc. 1986

Note on Purchasing Power Parity

I. Calculating Purchasing Power Parity (PPP) exchange rates The theory of PPP has been around for centuries but it remains controversial and economists still argue the assumptions behind its calculations and its validity in different applications. There are two commonly used approaches for calculating the PPP exchange rates, the absolute approach and the relative approach. Absolute approach to PPP Let us start with a simple illustration of prices of a few items of daily use in the United States and in India (Table -1). Column A shows the prices in the United States of some common items of daily use and Column B shows their prices in India in Indian Rupees. Column C converts the price in India from Rupees to US Dollars using nominal exchange rates. We observe that the equivalent prices of these items in India are very low compared to their prices in the United States. Table 1 - List of prices for common items in India and the United States Price in India in Rupees B 10 12 12 35000 Rupees converted to US$ using market exchange rate of 0.022* C 46.11 0.22 0.26 0.26 759 Implied PPP Exchange rate D = C/A 0.18 0.20 0.17 0.36

Item A 12oz cup of coffee A one Lb loaf of bread Price of 1 litre Bottled water "Dasani" Rent per month for a two Bedroom apartment*

Price in the US in $ A 1.2 1.29 1.5 2100

Note: These are some sample prices at similar locations based on authors’ experience and not collected through a published source * Based on a 1US Dollar = 46.11 Indian Rupees, source www.x-rates.com, 12/11/2005 ** Apartments considered in Boston for US and Mumbai in India, 1000 sq. ft. size

Dividing the price in column C with price in column A gives an exchange rate which is shown in column D. This value is the PPP exchange rate, using this to convert Indian Rupees into US Dollars would result in equivalent buying power for the two currencies. However as column D indicates we have different values for PPP based on what sample item we use. In order to counter this problem economists use a basket of goods and services, this is also...

Other Papers Like Purchasing Power Parity

The Historical Movement of the Yen and Dollar Exchange Rates

1529 words - 7 pages The Historical Movement of the Yen and Dollar Exchange Rates Johan Floyd Omoso Boles 173812 International Christian University International Finance Heather A. Montgomery Abstract: This study finds the purchasing power parity (PPP) model of exchange rates to explain movements in the yen-dollar exchange rate over the long run of twenty two years. The results show that this theory does not necessarily provide a satisfactory explanation

Forecasting Methods Essay

1461 words - 6 pages FIN 581 Week 5 Team 4 Forecasting Methods | | April 20, 2014 | TABLE OF CONTENTS Contents 1. Balance of payments, inflation and interest rates of United States and Japan. 3 2. Balance of payments forecast. 3 3. Purchasing power parity forecast. 4 4. Forward rate as unbiased predictor forecast. 4 5. Compare forecast. 5 6.  Compare past five day forecast and results. 5 Appendix 6 Table 1: Interest

Macroeconmic Perspective

1894 words - 8 pages gauging a country’s economic health as it characterizes the total market value of the goods and services produced within a specific timeframe. Gross Domestic Product figures are used to make comparisons of one country production with that of another country’s and of one year’s production with another year’s. Gross Domestic Product per capita founded on purchasing power parity (PPP) is the GDP changed to international dollars by means of the

Real Exchange Rate

671 words - 3 pages the nominal exchange rate times the domestic aggregate price level divided by the foreign aggregate price level. Intuition might suggest that real exchange rates should be equal to 1, since it's not immediately obvious why a given amount of monetary resources wouldn't be able to buy the same amount of stuff in different countries. This principle, where the real exchange rate is, in fact, equal to 1, is referred to as purchasing-power parity, and there are various reasons why purchasing-power parity need not hold in practice.

Groupe Ariel Sa Case Analysis

1621 words - 7 pages them at 12.19%. This rate is calculated by assuming that the purchasing power parity holds in this scenario. The company can do the feasibility analysis by looking at both from the subsidiary’s and parent’s perspective by assuming that the purchasing power parity holds. Hence, this rate can be regarded as opportunity cost of investment because it is the second best alternative for the company for investment purposes. So, the NPV can be

Hihihi

1300 words - 6 pages lebih tinggi dibandingkan dengan Negara lain maka mata uangnya akan cenderung melemah (relative inflation rate). Hal ini terkait dengan aspek purchasing power parity. Dimana ketika inflasi meningkat maka purchasing power parity akan menurun. Teori Paritas Daya Beli (Purchasing Power Parity Theory = PPPT) digunakan untuk menganalisa pengaruh inflasi antara dua negara terhadap kurs valas. Variabel-variabel yang digunakan dalam PPPT adalah

Meet the Brics

1098 words - 5 pages are observing in China and India, where middle classes growth is very quick. It is anticipated that within a decade, each of BRIC countries will demonstrate higher profits, amplified demand for capital, and stronger state currencies. As a result, overseas firms will desire to observe foremost financial pointers, as Purchasing Power Parity, Gross National Income and Human Development Index, in addition to developments in the cultural, political

International Business

3748 words - 15 pages FDI in other countries. 6. Clear understanding of Purchasing Power Parity and Imparity. Purchasing Power Parity • When we can buy exactly the same amount of goods in another country when we convert our currency to their currency Imparity • When we can buy more or less amount of goods when we convert one currency to another currency 7. Implication of 2nd version of capital market theory based on imperfect foreign exchange market

Country Report - the Italian Republic

871 words - 4 pages displays GDP based on purchasing-power-parity or (PPP). Italy’s infant mortality rate of 5.61% while it may not be exceedingly high its however exceeds the amount of children being born and thus the population is decreasing versus increasing. In addition, despite the country’s relatively high literacy rate of 98.4%, there is still 1.6% of the population whom are illiterate so its clear more money needs to be spent on education. Italy’s

Indian Economy

816 words - 4 pages largest in term of population. The economy of India is the largest economy in the indian by nominal GDP and the fourth largest by purchasing power parity (PPP). Understanding Indian Economy: Indian economy stands today as one of the influential and attractive economy. The liberalization move by the Indian Government in 1990s has given a boost to the Indian economy and put her into a fast track economic growth route. With the beginning of the new

Practice Midterm Solutions Fin 410 Spring 2007 Midterm 1-Solutions

1568 words - 7 pages $2.54 in the US and TL 4.89 in Turkey, according to law of one price, what should the $/TL exchange rate be? ______$0.5194/TL__________________ $2.54TL 4.89=$0.5194/TL If the actual exchange rate quoted in Wall Street Journal is TL1.2590/$, is the Turkish Lira, overvalued or undervalued? Why? 1/1.259 = $0.7943/TL TL overvalued MULTIPLE CHOICE ANSWER SHEET Questions | Answer Choice | Questions | Answer Choice | 1. | A | 6. | B | 2. | B | 7. | A | 3. | D | 8. | B | 4. | D | 9. | D | 5. | A | 10. | C | FORMULAS: INTEREST RATE PARITY PURCHASING POWER PARITY S = 1+ FISHER EFFECT INTERNATIONAL FISHER EFFECT

Related Essays

Purchasing Power Parity Essay

1461 words - 6 pages Purchasing power parity dates back several centuries but was actually introduced after World War 1. Before the war, gold standards were used but after the war it was difficult to continue this way because speculators were afraid countries would ask for high revenues after devaluing their currencies. Therefore, Cassel developed Purchasing Power Parity during the international policy debate when they were discussing about the nominal exchange

Does Purchasing Power Parity Hold? Essay

2893 words - 12 pages If we analyzed then we come to know that long-run purchasing power parity hold above the floating exchange rate epoch. Panel unit root tests offer facts of PPP that increases by means of the number of explanation. The intensification of the substantiation, nevertheless, is extremely cyclic. When the dollar appreciates at the end of the illustration, the facts of PPP strengthens and, when it depreciates, the fact weakens. At the same time as

Purchase Power Parity Theory Essay

1088 words - 5 pages Introduction - Purchasing Power Parity PPP Theory The first original reference of PPP Theory was made by David Ricardo. However, Gustav Cassel popularized this theory in 1918. According to PPP theory, when exchange rates are of a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations. Foreign currency is demanded by the people because it has

Macroeconomics; Money Essay

1654 words - 7 pages . goods and fewer goods from other countries. As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net exports. Conversely, an appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall. A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING-POWER PARITY The purchasing-power parity theory is the simplest and most