Purchasing Power Parity - Forex PPP
What is Purchasing Power Parity?
Purchasing power parity (PPP) is the theory that states that there is a relationship between the exchange rates of different countries and the price at which goods or services are sold in those countries. Forex purchasing power parity can also be expressed as the existence of equilibrium between currencies when their purchasing power is the same in each country.
The PPP can this is viewed in the light of the following formula:
Exchange Rate between countries = Price of Goods in Country X / Price of Goods in Country Y
The PPP theory was developed in 1920 by Gustav Cassel. Power parity purchasing is based on the “law of one price”. This theory expresses that in identical efficient markets, identical services or goods should have only one price. Purchasing Power Parity (PPP) is important to the foreign exchange market as it is a driving factor behind the movement of currencies on the foreign exchange market.
The importance of PPP
Purchasing power parity is used as a method to calculate the differences in the cost of living between countries.
The normal exchange rate can only reflects traded goods to non-traded ones. Normal market exchange rates can be used to compare the standard of living between different countries. The normal technique to calculate standard of living differences between countries normally involves the use of per capita gross domestic product technique The per capita Gross Domestic Product is calculated by the dividing the GDP of a country by the population of that country. The two totals are then expresses in the same currency. Many variables impact the foreign exchange market such as different interest rates, market speculation, hedging or control by central banks. These are all factors that can contribute to an inaccurate outcome of the per capita GDP method. Using this technique can produce misleading results of the standard of living in those countries. The PPP method is thus used to paint a more accurate picture.
In order to calculate the power parity purchases between two countries the price of “standard" goods that are identical in each country must be compared. Samples of a basket of standard goods and services can include the following: Consumer goods and services, Equipment goods, Construction projects and services, and Government services.
Short term fluctuations in prices of services and goods will lead to an inaccurate power parity purchase. Traders should use the purchase of power parity results for long term analysis to enable an accurate outcome.
Factors such as differences in tax regulations and trade restrictions by different countries will influence the outcome of the PPP result. The purchase of power parity exchange rate will only be as accurate as the choice of goods used in the comparison index.
By choosing the wrong basket of goods or services, the outcome may accidentally be misinterpreted. Distinguishing between the quality of goods in one country and the equivalent goods in another will have an effect on the outcome of the PPP result.