Purchasing Power Parity

Purchasing Power Parity

DEFINITION

Purchasing Power Parity (PPP) was brought up in 1916 by Custov Cassell (DJ Family, 2004). The idea is that regardless of the transaction cost and the limitation of the country in which the good is purchased or sold, the cost of the good should be the same (Ross S.A. etc., 1998). The only difference is the price of the good is varied because of the different currency. In other words, PPP shows that the price of the good in different currencies is balanced by the exchange rate.

BASIC CONCEPT AND CONSTRUCTION

PPP can be divided into two models: absolute purchasing power parity (APPP) and relative purchasing power parity (RPPP). According to Ross S.A. (2001), APPP means that wherever the good is purchased, in whatever the currency, the cost of the good is the same. Taking British Pounds and US Dollars as an example, it can be showed as the following formula:

Puk＝ S0×Pus .

S0 stands for the spot rate of the British Pound; Puk and Pus are prices of the good in the UK market and the US market. The formula shows the price of the good in the UK market is equal to the price in the US market adjusted by the exchange rate.

APPP can also be explained by the concept of triangle arbitrage. If APPP is untenable, the good can be transported from a market to another for the arbitrage. Assume that the price of the good is ￡3 in the British market and ＄5 in the US market, which means the exchange rate of pounds in direct quote should be ￡0.6. The formula can be shown as followed:

￡3＝￡0.6×＄5 .

If the spot rate is ￡0.5, the seller can buy the good in the US market by paying ＄5 and sell it in the British market in ￡3. The income in pounds can be exchanged into dollars by the spot rate:

￡3/0.5＝＄6 .

The profit should be ＄6－＄5＝＄1. This business could increase the demand for US dollars and the supply of pounds in the same time. Therefore, the spot rate would be adjusted to a balance such that the...