The purchasing power parity notes Y12 Economics - September 2016

Revision PPP -> What Exchange Rates to compare GDP between countries? We use the costs of similar goods in Japan and USA to set the exchange rate to compare GDP. Lets say we just use the price of Big Macs: A Big Mac costs ¥200 in Japan, $4 in USA. So the Purchasing Power Parity Exchange Rate is ¥200/$4 = ¥50/$1 or ¥50 per $1 = $4.00

Notes – PPP Key Facts Price the same basket of goods in different countries and calculate a PPP exchange rate / 1 USD PPP seeks to establish an exchange rate that reflects the cost of living in reach country Then GDP/Capita can be compared to evaluate how each country is performing economically

Why may PPP not work well? Assumes no transport costs Assumes no tariff barriers (ie EU Common External Tariff) / Quotas on imports (limiting the volume of goods allowed to be imported) / taxation (Differing tax rates in each country) Assumes no government free provision of subsidisation of goods (Health care free in UK at point of delivery – not so in USA) Assumes similar goods are available in all countries (ie Rice as a staple crop in Asia – not so much in Norway). Assumes perfect information for all buyers and sellers Assumes homogenous goods (A Big Mac is, a “Car” less so)

What goods are suitable for a PPP basket? Only highly tradable goods with low transport costs A unit of currency ie £1 Gold or other precious metal High value technology such as iPhone Consumer staple supplied by TNC (The Big Mac Index) Won’t apply on non-tradable goods like: healthcare (especially pharmaceuticals) or goods with significant transport costs relative to their value ie sugar, wheat, scrap metal or where such a good doesn’t exist ie Solar Panels in Iceland, Beef in many parts of India, Wine and Beer in Saudi Arabia, Surf boards in Norway etc.

Market Exchange Rates (28.9.16) PPP vs Market Exchange Rates: Market Rates used by Banks - you use these when changing money on holiday. Market Exchange Rates (28.9.16) $1 = £0.76 $1 = €0.90 $1 = ¥100 $1 = A$1.30

Exercise: Big Mac Index, PPP can be used to see if a currency is over or under valued http://www.economist.com/node/581914 Read 1st 5 paragraphs and have a look at the chart Using the Japanese Yen example see if you can figure out how they did their calculations to establish if a currency is under or over valued – discuss with your colleagues

PPP vs Market Exchange Rates Big Mac in USA Big Mac in Japan 294 = ----- 2.54 Set by the Market USA The Key Bit: PPP rate is $1 buys ¥116 BUT Market Rate $1 buys ¥123.5 (¥ is weaker in the Market, as more must be given for $1……… SO Market is undervaluing ¥ by around 6% compared to PPP).