Understanding purchasing power parity
Purchasing power parity (PPP) is a way of measuring the true value of different currencies. Instead of evaluating currencies just based on their exchange rates, purchasing power parity compares their buying power.
The purchasing power parity of two different countries is often different from their exchange rate. It is based on the ‘law of one price’ theory which contends that the price of an identical basket of goods and services will have the same price globally once regional factors are taken into account.
Traders can use PPP to evaluate if a currency is over or undervalued based on its real purchasing power. This is based on the expectation that the PPP between two countries impacts the exchange rate, with both forces pulling on each other to reach an equilibrium. At this equilibrium, the PPP of two currencies is expected to match the exchange rate.
So, according to the underlying theory of purchasing power parity, if a particular basket of goods costs more in one country than another after exchange rates are considered, the country with the higher price has an overvalued currency. On the other hand, the country with the lower-valued basket has an undervalued currency.
Purchasing power parity often uses a price index to compare the cost of a basket of goods. One popular index is the Consumer Price Index (CPI). To determine an equilibrium exchange rate, economists calculate the ratio of both price levels using an index like the CPI.
What is purchasing power parity used for?
Purchasing power parity is monitored by governments and central banks to evaluate the competitiveness of a currency in the global market. Economists pay close attention to the level of competitiveness. That’s because one currency being significantly over or undervalued can have drastic consequences on a country’s international trade.
Overvalued currencies, those with a high PPP, make a country’s exports more expensive. This may cause demand to drop as international consumers purchase those goods and services from cheaper countries. Undervalued currencies can boost demand for exports. But they may also cause inflationary pressure at home.
What does purchasing power parity mean for forex trading?
You can use purchasing power parity when trading forex to identify potential misalignments in exchange rates. If a currency is considered overvalued based on PPP, it may present a selling opportunity as the market corrects itself. Conversely, an undervalued currency may provide a buying opportunity with the anticipation of currency appreciation.
This theory of what PPP means for currency markets is based on the free-market theory that currency exchanges are self-correcting. In the long run, many economists assume exchange rates will adjust to ensure purchasing power parity. So, currencies overvalued according to PPP will depreciate, and currencies undervalued will appreciate.
Comparing the purchasing power parity of two currencies can help forex traders gain insight into how a currency pair might move in the future. Depending on other fundamental conditions of the currencies, you might anticipate the exchange rate will readjust towards equilibrium or continue moving apart. After calculating the PPP and determining the exchange rate is not at equilibrium, you might decide the trend will continue and the discrepancy will widen. Of course, there are many other factors affecting prices and exchange rates which can erode or completely overpower market movement forecasted by PPP.
How to calculate purchasing power parity
You can calculate purchasing power parity the same way you would an exchange rate. The only difference is that you are calculating the exchange rate based on a price index.
S = P1 / P2
In this formula ‘S’ equals the exchange rate, ‘p1’ equals the cost of a basket of goods in one currency and ‘P2’ equals the cost of the same basket of goods in the second currency.
Then you can compare the PPP result to the actual exchange rate. If the exchange rate is higher, the first currency (P1) may be overvalued. If the exchange rate is lower than the PPP, the second currency (P2) may be overvalued. In the next section, we compare a calculated PPP to the exchange rate of GBP/USD.
How to compare purchasing power parity of two countries
Making an accurate comparison of prices between two countries is made complicated by trying to create wide-ranging but equal baskets of goods. There are some global goods you can compare as a stand-in for a basket, and some people use CPI to calculate PPP. Major economic organisations might also report purchasing power parity calculations every so often.
The World Bank releases a report comparing various countries by purchasing power parity every few years. The release of these figures often has immediate short-term effects on financial markets, and organizations like the International Monetary Fund will use the reports to recommend long-term policy decisions.
Big Mac Index
The Big Max index is probably the most famous measure of purchasing power parity. Instead of comparing an entire basket of goods, it compares the price of a McDonald’s Big Mac in different countries.
The Big Mac functions as a basket of sorts, because it uses the same ingredients in most countries. All you need to do to calculate PPP with the Big Mac index is plug the price of a Big Mac from two different countries into the formula.
If the cost of a Big Mac is £3.79 in the UK and $4.67 in the US, the PPP for a USD/GBP exchange rate would be:
$4.67/£3.79 = 1.23
The exchange rate for GBP/USD is currently about 1.24, making the exchange value of the pound slightly higher than its purchasing power according to the Big Mac index.
Using a popular product of a global company has become more commonplace for calculating PPP. Another popular index is the Tall Latte index, which uses a tall latte from the international coffee chain Starbucks.
Drawbacks of purchasing power parity
As you might have guessed, there are many factors that prevent purchasing power parity from establishing equilibrium between two countries. Firstly, the cost of goods and services in different countries depends on the availability of resources and government subsidies. The most common factors to impact calculations of PPP include:
- Transport costs: Some countries have goods and products more readily available while others must pay more to import them
- Competition: Goods and services may be priced differently in various regions by the same company depending on the level of competition in the region
- Taxes: Different structures to government sales taxes can create differences in price
- Government intervention: Government action like tariffs or free trade agreements can drastically alter the price of imported goods
Ultimately, calculating purchasing power parity is a difficult task. There are also stand-ins you can use in place of a broad basket of goods. Evaluating the PPP of different companies can indicate potential shifts in an exchange rate.
It’s important to remember there are many influences on an exchange rate, and PPP should be reviewed with additional fundamental and technical analysis. You can practice evaluating a currency’s value with the purchasing power parity by opening a City Index demo account.