Absolute form of purchasing power parity: Meaning, Criticisms & Real-World Uses

What Is Absolute Purchasing Power Parity?

Absolute purchasing power parity (PPP) is an economic theory within the field of international macroeconomics that postulates that identical goods and services should cost the same in different countries when expressed in a common currency. This theory is based on the "law of one price," which suggests that in the absence of transaction costs and trade barriers, identical goods sold in different markets must have the same price. Absolute purchasing power parity aims to determine the equilibrium exchange rate between two currencies by comparing the prices of a representative basket of goods and services. The core idea behind absolute purchasing power parity is that a unit of a currency should have the same purchasing power globally.

History and Origin

The concept of purchasing power parity has roots tracing back to the 16th century, but its modern development and formalization are widely credited to the Swedish economist Gustav Cassel in 1918. Cassel introduced the phrase "purchasing power parity" in his writings, particularly in the context of analyzing exchange rates during and after World War I, when many countries abandoned the gold standard¹¹. He argued that if an exchange rate was out of sync with the relative purchasing powers of two currencies, it would create opportunities for arbitrage through international trade, which would eventually force the exchange rate back to a level where the purchasing power was equalized¹⁰.

Key Takeaways

Absolute purchasing power parity (PPP) asserts that a common basket of goods should cost the same across different countries when prices are converted to a single currency.
It is fundamentally based on the "law of one price."
The theory helps in comparing living standards and economic output between nations by adjusting for price level differences.
Empirical evidence often shows significant deviations from absolute PPP due to various real-world factors.
It serves as a long-run benchmark for exchange rates rather than a precise short-run predictor.

Formula and Calculation

The absolute purchasing power parity relationship can be expressed with a straightforward formula that equates the exchange rate to the ratio of price levels in two countries.

The formula for absolute PPP between two currencies is:

S = \frac{P_1}{P_2}

Where:

( S ) = The nominal exchange rate of currency 1 to currency 2 (units of currency 2 per unit of currency 1).
( P_1 ) = The price of a specific basket of goods in currency 1 (the home country).
( P_2 ) = The price of the identical basket of goods in currency 2 (the foreign country).

For example, if a standard basket of goods costs $100 in the United States (( P_1 )) and an identical basket costs €90 in the Eurozone (( P_2 )), then the absolute PPP exchange rate (( S )) would be:

S = \frac{\$100}{€90} \approx 1.11 \text{ \text{dollars per euro}}

This suggests that, according to absolute PPP, the exchange rate should be approximately $1.11 for every euro to ensure equal purchasing power.

Interpreting the Absolute Purchasing Power Parity

Interpreting absolute purchasing power parity involves understanding what the calculated exchange rate implies about currency valuation and economic comparison. When the actual foreign exchange market rate deviates from the absolute PPP rate, it suggests that one currency is either overvalued or undervalued relative to another. For instance, if the actual market exchange rate for the euro is $1.20, but the absolute PPP rate is $1.11, the euro would be considered overvalued. Conversely, if the market rate was $1.00, the euro would be undervalued based on absolute PPP.

These deviations indicate potential arbitrage opportunities or underlying economic discrepancies not accounted for by the pure theory. Absolute PPP helps economists and policymakers assess the relative cost of living and the true economic size of countries beyond what nominal gross domestic product (GDP) figures alone might suggest. It provides a benchmark for evaluating long-term trends in currency values and assessing whether a currency's current value is sustainable given relative price levels.

Hypothetical Example

Consider the price of a specific smartphone model available globally. In Country A, this smartphone costs 1,000 units of local currency (Currency A). In Country B, the exact same smartphone costs 800 units of local currency (Currency B).

To calculate the absolute purchasing power parity exchange rate between Currency A and Currency B, we apply the formula:

( S = \frac{P_A}{P_B} )

Where:

( S ) = Exchange rate (units of Currency A per unit of Currency B)
( P_A ) = Price in Country A = 1,000 Currency A
( P_B ) = Price in Country B = 800 Currency B

S = \frac{1,000 \text{ Currency A}}{800 \text{ Currency B}} = 1.25 \text{ Currency A per Currency B}

This means that, according to absolute PPP, 1 unit of Currency B should be able to purchase 1.25 units of Currency A. If the current exchange rate in the foreign exchange market is, for example, 1.50 Currency A per Currency B, then Currency B is overvalued relative to Currency A based on this specific product. Conversely, if the market rate were 1.00 Currency A per Currency B, Currency B would be undervalued.

Practical Applications

Absolute purchasing power parity finds several practical applications, particularly in the realm of international economics and comparative statistics. One of its primary uses is in comparing economic output and living standards across different countries. Organizations like the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) use PPP-adjusted data for more meaningful cross-country comparisons of macroeconomic indicators like GDP per capita.

F⁹or example, when evaluating the true size of an economy or the welfare of its citizens, simply converting GDP using market exchange rates can be misleading, especially for developing countries where non-traded goods and services tend to be cheaper. By⁸ using PPP, which accounts for these price differences, economists can get a more accurate picture of the real purchasing power within an economy. This adjustment allows for a "like-for-like" comparison, reflecting what a country's currency can actually buy domestically, rather than just its value in international financial transactions. Wh⁷ile not a perfect tool, it helps in gauging global poverty thresholds and constructing indices like the Human Development Index.

Limitations and Criticisms

Despite its theoretical appeal, absolute purchasing power parity faces significant limitations and criticisms in its real-world application. One major challenge is the assumption of perfectly free trade and the absence of transaction costs, such as tariffs, quotas, and transportation expenses. In⁶ reality, these barriers distort prices and prevent the "law of one price" from holding true across borders.

A⁵nother significant issue stems from the existence of non-tradable goods and services, such as real estate, haircuts, or local transportation, which are not subject to international trade and thus their prices are not directly equalized by arbitrage. Th⁴e prices of these non-tradables can vary significantly between countries, impacting the overall price level used in PPP calculations. Furthermore, differences in product quality, consumer preferences, market structures (e.g., monopolies), and tax policies can all lead to deviations from absolute PPP. As³ noted by economist Paul Samuelson, PPP can be a "misleadingly pretentious doctrine, promising us what is rare in economics, detailed numerical prediction". Em²pirical studies often show that absolute PPP does not hold consistently in the short run and can even deviate persistently over longer periods, influenced by factors like productivity differentials (Balassa-Samuelson effect) and capital movements.

#¹# Absolute Purchasing Power Parity vs. Relative Purchasing Power Parity

While both concepts fall under the umbrella of Purchasing Power Parity (PPP) and aim to relate exchange rates to price levels, absolute purchasing power parity and relative purchasing power parity differ in their focus. Absolute PPP states that the level of the exchange rate between two currencies should equal the ratio of the two countries' price levels for an identical basket of goods. It is concerned with the level of prices and exchange rates at a given point in time. It inherently assumes that the "law of one price" holds for all goods in the basket, leading to a constant real exchange rate of one.

In contrast, relative purchasing power parity is a weaker version of the theory that focuses on changes in price levels and their effect on exchange rates over time. It posits that the percentage change in the exchange rate between two currencies should offset the difference in their respective inflation rates. Relative PPP does not require the "law of one price" to hold or for the real exchange rate to be constant; it only requires that any deviations from absolute PPP remain consistent over time. Consequently, relative PPP is often considered a more realistic and empirically supported concept, particularly over longer horizons, as it accounts for differential inflation rates impacting currency values without demanding strict price equalization across borders.

FAQs

What is the primary purpose of Absolute Purchasing Power Parity?

The primary purpose of absolute purchasing power parity is to compare the purchasing power of different currencies by establishing a theoretical exchange rate that would equalize the prices of an identical basket of goods and services across countries. This helps in understanding the true cost of living and the real economic size of nations.

Why doesn't Absolute PPP always hold true in reality?

Absolute PPP often fails to hold true due to factors like transportation costs, tariffs, and other trade barriers that prevent perfect arbitrage. Additionally, the presence of non-tradable goods and services, differences in product quality, and varying tax structures across countries contribute to price discrepancies that absolute PPP does not fully account for.

How does Absolute PPP relate to the "Law of One Price"?

Absolute PPP is a macro-level extension of the "law of one price." The "law of one price" states that identical goods should have the same price in different markets when expressed in a common currency. Absolute PPP applies this principle to a broad basket of goods and services, suggesting that the aggregate price levels should be equalized through the market equilibrium exchange rate.

Is Absolute PPP used for short-term exchange rate forecasting?

No, absolute PPP is generally not considered reliable for short-term exchange rate forecasting. It is a long-run equilibrium theory and its predictions are often significantly deviated from by market exchange rates in the short to medium term due to factors like interest rates, capital flows, and monetary policy. Its utility is more in long-term economic comparisons and as a theoretical benchmark.