Purchasing Power Parity (PPP)
Purchasing Power Parity, PPP, can be used to obtain a picture of a currency is over-or undervalued.
Purchasing power parity indicates what you can buy in each country for a certain sum of each country’s currency. With other words, its a way to eliminate differences in price levels between countries or a way to do valuation of a currency.
It can be quite easy to count out a notional exchange rate based on purchasing power parity by making the following calculation. Let us take the Sterling and the U.S. Dollar as an example. A basket of currencies compiled with similar goods in both countries, United Kingdom and the United States of America. Then note the price for each basket in local currencies.
[Price of the basket in Sterling / price of the basket of the U.S. Dollar].
Then you can compare with the current exchange rate on the market to get a picture on the currency is over-or undervalued.
It is important however that you are using a basket of currencies consisting of similar goods and services to calculate purchasing power parity. However, it may be easier said than done to get a similar cart, since consumers between countries may have different preferences. As an example, perhaps average Americans consumer drive their cars way more and drink considerable more Coca-Cola, while the Brits are traveling abroad more.
Anyway, the logic of PPP is based on “The Law of One Price ‘in which two identical goods should cost the same in all countries. It may, however, take into account transport costs, VAT and in some cases customs charges.
Unless the price is the same, it leads to arbitrage opportunities, ie the ability to buy the products in the country where it is cheapest to resell them in the country where they are most expensive and earn good money at it.
Short term, there are such possibilities, but in the long run, these differences tend to be eliminated either by changes in currency exchange rates or by price differences leveled down.
PPPs have a connection with the exchange rate in the long run, but it’s nothing a Daytrader currency normally watch.
If we take an example from Norway who has the 3rd highest GDP per capita in the world with over 102 000 U.S. Dollar and the U.S. is number 17 on the list with just over 47 000 U.S. Dollar. Both figures are taken from the IMF’s expectations for 2008.
With the above figures would be quite easy to say that the standard of living is 2 times higher in Norway than in the United States. But by looking at PPP per capita, you get a different picture. By eliminating price variations Norway retains its third place with just over 55 000 U.S. Dollar and U.S. ports in sixth place with 47 000 U.S. Dollar, U.S. and PPP GDP figure is the same as using the U.S. as the base.
Here you can see that the variation becomes smaller and you get a slightly better picture of countries’ level of living. This also gives a clear picture of eg the Norwegian price level is much higher than the U.S.: P. Since it would be very careful to say that Norway has had higher inflation than the U.S.. However, it is very important to note that there are statements on inflation should not be made between countries with very different economic conditions, such as the United States and Burma.