Purchasing Power Parity

Other than GDP, PPP can give economists a look into how a nation is doing economically PPP measures a countries living standard over a given period of time. PPP can be used to see how much a person within a country can buy with their currency

Purchasing Power Parity What does PPP have that GDP doesn’t? PPP compares goods that are common amongst nations PPP then measures how much of a good can be bought using their currency It gauges the standard of living based on currency and purchasing power (get it?) It is a way to look at wealth without being distorted by price levels.

Purchasing Power Parity Example: Lets look at a common good, shoes. We want to compare shoe prices in Japan and the U.S. Lets say the exchange rate between the yen and dollar: 1 yen for 2 dollars So a pair of shoes costs 30 yen in Japan. Based on this exchange rate a pair of Nikes will cost $60 here in the U.S.

Purchasing Power Parity Seems easy right? But what happens when goods don’t follow the exchange rate?

Purchasing Power Parity In this example we are looking at the price of baseball bats in Mexico and the U.S. In the U.S. bats sell for $40 In Mexico bats sell for 150 pesos Our exchange rate here is 1 USD = 10 pesos We see here that the price of baseball bats does not follow the exchange rate, therefore it is cheaper to buy bats in Mexico

Purchasing Power Parity Will this always be the case for the U.S. and Mexico? Lets look at what is going to happen here

Purchasing Power Parity U.S. customers are going to see that they can save money by buying bats in Mexico Therefore they will sell their American dollars to buy pesos This will cause a higher demand in pesos This means the peso will grow in value compared to the dollar The drop in demand for U.S. bats will go down due to the increase demand for Mexican Baseball bats Now Louisville Slugger will have to lower their prices to compete Mexican baseball bat producers will see that their market has expanded and will start charging more for their bat Lowering prices in the U.S. and increasing prices in Mexico will lead to….

Purchasing Power Parity MARKETS EQUALING EACH OTHER!

Purchasing Power Parity Through trade and specialization the costs of goods should equal out However, on the road to this equilibrium we will experience some differences in price and dollar value

Moffatt, M. (n.d.). Guide to Purchasing Power Parity Theory (PPP Theory). Retrieved August 9, 2015, from Citations