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Purchasing-power parity theory. A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

In short, what this means is that a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account. To see why, we’ll use an example.
First suppose that one U.S. Dollar (USD) is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the United States wooden baseball bats sell for $40 while in Mexico they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico. Clearly there’s an advantage to buying the bat in Mexico, so consumers are much better off going to Mexico to buy their bats. If consumers decide to do this, we should expect to see three things happen:

American consumers desire Mexico Pesos in order to buy baseball bats in Mexico. So they go to an exchange rate office and sell their American Dollars and buy Mexican Pesos. As we saw in "A Beginner’s Guide to Exchange Rates" this will cause the Mexican Peso to become more valuable relative to the U.S. Dollar.

The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down.

The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up.

Eventually these three factors should cause the exchange rates and the prices in the two countries to change such that we have purchasing power parity. If the U.S. Dollar declines in value to 1 USD = 8 MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have purchasing power parity. This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so. You might think that my example of consumers crossing the border to buy baseball bats is unrealistic as the expense of the longer trip would wipe out any savings you get from buying the bat for a lower price. However it is not unrealistic to imagine an individual or company buying hundreds or thousands of the bats in Mexico then shipping them to the United States for sale. It is also not unrealistic to imagine a store like Walmart purchasing bats from the lower cost manufacturer in Mexico instead of the higher cost manufacturer in Mexico. In the long run having different prices in the United States and Mexico is not sustainable because an individual or company will be able to gain an arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other market (This is explained in greater detail in “What is Arbitrage? ”).

Since the price for any one good should be equal across markets, the price for any combination or basket of goods should be equalized. That’s the theory, but it doesn’t always work in practice.

Why Purchasing Power Parity Theory Isn’t Perfect?

Anything which limits the free trade of goods will limit the opportunities people have in taking advantage of these arbitrage opportunities. A few of the larger limits are:

1) Import and Export Restrictions: Restrictions such as quotas, tariffs and laws will make it difficult to buy goods in one market and sell them in another. If there is a 300% tax on imported baseball bats, then in our first example it is no longer profitable to buy the bat in Mexico instead of the United States. The U.S. could also just pass a law make it illegal to import baseball bats. The effect of quotas and tariffs were covered in more detail in "Why Are Tariffs Preferable to Quotas? ".

2) Travel Costs: If it is very expensive to transport goods from one market to another, we would expect to see a difference in prices in the two markets. This even happens in places that use the same currency; for instance the price of goods is cheaper in Canadian cities such as Toronto and Edmonton than it is in more remote parts of Canada such as Nunavut.

3) Perishable Goods: It may be simply physically impossible to transfer goods from one market to another. There may be a place which sells cheap sandwiches in New York City, but that doesn’t help me if I’m living in San Francisco. Of course, this effect is mitigated by the fact that many of the ingredients used in making the sandwiches are transportable, so we’d expect that sandwich makers in New York and San Francisco should have similar material costs. This is the basis behind the Economist’s famous Big Mac Index. Their article McCurrencies is a must read.

4) Location: You can’t buy a piece of property in Des Moines and move it to Boston. Because of that real-estate prices in markets can vary wildly. Since the price of land is not the same everywhere, we would expect this to have an impact on prices, as retailers in Boston have higher expenses than retailers in Des Moines.

So while purchasing power parity theory helps us understand exchange rate differentials, exchange rates do not always converge in the long run the way PPP theory predicts.

# posted by Rajpal Rao : 1:34 AM