PPP, which is purchasing power parity, is a theory economically that takes different countries’ currencies and compares them using an approach called basket of goods. The currencies are in balance, which is known as being at par; the exchange rate is considered what the basket of goods at the same price in each country (Hall,2019). There are several calculations throughout Chapter 10, even one related to the comparison of Big Mac prices, which showed prices could be overvalued or undervalued, United Stated $5.06, China $2.83, and $5.67 in Norway (Hill, 2019, p.296). I would love to pay a lower price for an item; however, the quality of the product may not be the same and may vary from country to country. Not all goods are traded between all countries, and the weight attached to similar goods in aggregate price indices will differ across countries. A Big Mac cannot be traded internationally or not easily at least: each good contains a high service componentthe wages of the person serving the food and drinkand a high property rental componentthe cost of providing you with somewhere to sit and sip your coffee or munch your two beef patties on a sesame seed bun with secret-recipe sauce ( Taylor & Taylor, 2004).
The information provided puts the topic reference to price parity inspective for me. The equations in the textbook provide excellent examples of currency changes and give formulas that lead me to think the PPP theory is involved and can become a convoluted process due to Gross Domestic Product, etc. To get a better illustration of GDP and how it is combined with purchase power parity, suppose it costs $10 to buy a shirt in the U.S., and it costs 8.00 to buy an identical shirt in Germany. To make a comparison, there must be a conversion of 8.00 into U.S. dollars. If the exchange rate were such that the shirt in Germany costs $15.00, the purchasing power parity would, therefore, be 15/10, or 1.5. In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany, buying it with the euro (Hall,2019).
According to this theory, for example, the U.S. inflation rate is higher than the Canadian inflation rate, then the purchasing power of Americans will erode compared to that of Canadians, and the value of the U.S. dollar against the Canadian dollar will be adjusted in the markets to balance the purchasing power of the two currencies. Theoretically, the adjustment will equal the difference in the two countries inflation rates. For example, if inflation is running at six percent in the United States and at three percent in Canada, the Canadian dollar should gain three percent in value against the U.S. dollar (Roy, 2016).
References
Hall, M. (2019) What is Purchasing Power Parity (PPP)? Retrieved from
https://www.investopedia.com/updates/purchasing-power-parity-ppp/
Hill, C.W. (2019). International Business: Competing in the Global
Marketplace 12th ed. New York, NY: McGraw Hill Education.
Roy, E. (2016) Which Theory Will You Predict Future Foreign Rates.
Retrieved from http://www.tradeready.ca/2016/topics/international-trade-finance/theory-predict-foreign-exchange-rates/
Taylor, A. & Taylor, M. (2004) The Purchasing Power Parity Debate. Journal of Economic
Perspective, Volume 18 18, Issue 4, p.135-158
Retrieved from https://www.ssc.wisc.edu/~mchinn/taylor&taylor_PPP_JEP.pdf
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