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Monday, September 16, 2013

An Overview of Purchasing Power Parity (PPP) With Example and Explanation

What is Purchasing Power Parity (PPP): When the currency exchange rate between two countries are in equilibrium condition which means the purchasing power is the same between two countries goods and services then we express it with the term Purchasing Power Parity.

An example will make you clear; suppose a Cadbury dairy milk chocolate sells for Rs. 15 in India should cost Tk. 20 in Bangladesh when the exchange rate between India and Bangladesh is 1.34Tk/Rs. If the price of the Cadbury dairy milk in India was only Rs. 10, consumers of Bangladesh would prefer buying the Cadbury dairy milk chocolate from India. If this process is carried out at a large scale, the Bangladeshi consumers buying Indian products will bid up the value of the Indian Rupee thus make Indian goods more costly to them. This process continues until the goods have again the same price. The foundation of Purchasing Power Parity is the "law of one price". There are three limitations with this law of one price. These are:

1) Only tradable goods will be considered under this law.
2) Goods and service market should be competitive in both countries.
3) Transportation costs, transaction costs, and barriers to trade can be significant.

There are two types of purchasing power parity. One is absolute purchasing power parity and another one is relative purchasing power parity. Absolute purchasing power parity refers to the equalization of price level across countries.

Relative purchasing power parity refers to rates of changes of price levels, that is, inflation rates. For example, if Bangladesh has an inflation rate of 1% and the India has an inflation rate of 3%, the Indian rupee will depreciate against the Bangladeshi taka by 2% per year. 
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