Sunday, March 22, 2015

Purchasing Power Parity (PPP)


PPP Theory
It states that the exchange rate of a currency with another (currency) is in equilibrium when their domestic purchasing power are equivalent at that exchange rate.

It means that a good should cost same in India and USA after considering the exchange rate of Indian Rupee (INR) and US Dollar (USD).


Example
Suppose, the current exchange rate of Indian rupee to US Dollar is Rs. 60 per USD (i.e., 1 USD = Rs. 60). Now suppose a laptop costs Rs. 60,000 in India.

According to the PPP theory, the laptop should cost USD (60,000 / 60) = USD 1,000 (considering the current exchange rate of these two currencies) to maintain parity in purchasing power of these two currencies.

But, it may happen that the actual market price of the laptop in USA is USD 800 (say) (equivalent to Rs. 48,000 in India). Therefore, there is an advantage of buying the laptop in USA at much less price than India (Rs. 12,000 less) (it means that the purchasing power is not in parity between these two currencies)


What happens if not in parity?
Indian consumers will go to the exchange office and sell their INR and buy USD, and then buy the laptop from USA. It will cause the Indian currency less valuable than the US dollar.

The demand of laptop sold in India will decrease (since high price), and the price of laptop will go down. In contrast, the demand of laptop in USA will increase, and the price will rise accordingly.

These factors will cause the exchange rate (of the currencies) and the prices (of laptops) to change such that there is purchasing power parity in both the currencies.


Long term effect
PPP theory tells us that the price differences between countries are not sustainable in the long run, as market forces will equalize prices between the countries and change the exchange rates accordingly.

(Relate the above example with companies that can buy goods in much less price from foreign countries and sell in much less price in India than its counterparts. For this reason, there are several laws or restrictions on imports and a provision of levying customs duty, etc.)



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