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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 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, 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...

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