Absolute purchasing power parity

Absolute purchasing power parity is a core concept within [TERM_CATEGORY] that suggests that a given basket of goods and services should cost the same in two different countries when expressed in a common [currency valuation]. This economic theory posits that the [exchange rate] between two currencies should naturally adjust to reflect the ratio of their national [price level]s, thereby ensuring equal [purchasing power] across borders for identical goods⁷⁶, ⁷⁷. It is built upon the fundamental [economic theory] of the [law of one price], which states that in efficient markets, identical goods should have only one price when converted to a common currency⁷⁴, ⁷⁵. Absolute purchasing power parity (PPP) serves as a theoretical benchmark for understanding the equilibrium state of currencies, disregarding factors like [transportation costs] and [trade barriers]⁷³.

History and Origin

The concept of purchasing power parity has roots tracing back to the 16th century, but it was rigorously developed and popularized by Swedish economist Gustav Cassel in 1918, following World War I.⁷⁰, ⁷¹, ⁷² Cassel introduced the term "purchasing power parity" as a means to explain and predict exchange rates during a period of significant monetary instability.⁶⁸, ⁶⁹ His theory was based on the idea that the value of a country's currency is fundamentally determined by what it can buy domestically.⁶⁷ He proposed that if the market exchange rate deviated from this implied PPP rate, market forces, primarily through [arbitrage] in internationally traded goods, would eventually push the exchange rate back toward parity.⁶⁶ While Cassel initially presented a rather dogmatic definition, his later works introduced nuances and restrictive assumptions, adapting the theory to real-world complexities.⁶⁵

Key Takeaways

Absolute purchasing power parity (PPP) proposes that the exchange rate between two currencies should equal the ratio of their general price levels, meaning a basket of goods should cost the same in both countries when converted to a single currency.⁶³, ⁶⁴
It is rooted in the "law of one price," which suggests identical, freely traded goods should sell for the same price globally, assuming no trade barriers.⁶¹, ⁶²
The theory serves as a theoretical benchmark for equilibrium exchange rates, abstracting from real-world frictions like tariffs and transportation costs.⁶⁰
While useful for long-term economic comparisons and understanding currency undervaluation or overvaluation, absolute PPP rarely holds precisely in the short to medium term due to various market imperfections.⁵⁷, ⁵⁸, ⁵⁹
Economists and international organizations use PPP-adjusted figures to make more meaningful comparisons of [gross domestic product (GDP)] and living standards across countries.⁵⁵, ⁵⁶

Formula and Calculation

Absolute purchasing power parity is calculated by comparing the price of an identical basket of goods and services in two different countries. The formula aims to determine the theoretical [nominal exchange rate] that would equalize prices.

The formula for the absolute PPP exchange rate ((E_{PPP})) between two currencies is:

E_{PPP} = \frac{P_A}{P_B}

Where:

(E_{PPP}) = The absolute purchasing power parity exchange rate (units of currency A per unit of currency B)
(P_A) = The price of a specific, identical basket of goods and services in Country A (in Country A's currency)
(P_B) = The price of the same specific, identical basket of goods and services in Country B (in Country B's currency)⁵⁴

For example, if a standard basket of goods costs $100 in the United States and £80 in the United Kingdom, the absolute PPP exchange rate would be $1.25 per £1 (($100 / £80)). This implies that, theoretically, £1 should be able to buy $1.25 worth of goods.

##⁵³ Interpreting the Absolute Purchasing Power Parity

Interpreting absolute purchasing power parity involves comparing the calculated PPP exchange rate with the actual market [foreign exchange market] rate. If the market exchange rate deviates significantly from the absolute PPP rate, it suggests that one currency might be [undervalued or overvalued]. For instance, if the PPP rate indicates that 1 USD should buy 80 Indian Rupees, but the actual market [exchange rate] is 70 Indian Rupees per USD, then the Indian Rupee would be considered undervalued relative to the U.S. dollar, and the dollar overvalued, based on this theory.

A⁵² lower cost of the identical basket of goods in a foreign country, after converting prices to a common currency using the actual exchange rate, indicates that the foreign currency is undervalued according to PPP. Conversely, a higher cost suggests the foreign currency is overvalued. How⁵¹ever, it is important to note that these interpretations are based on a theoretical ideal and do not always manifest in immediate market corrections due to various real-world factors.

##⁵⁰ Hypothetical Example

Consider a hypothetical scenario comparing the cost of a standardized consumer electronics device in Japan and the United States to illustrate absolute purchasing power parity.

Let's assume:

Price of the device in the U.S. ((P_{US})): $500
Price of the identical device in Japan ((P_{JP})): ¥60,000

To find the absolute PPP exchange rate (Japanese Yen per U.S. Dollar), we would use the formula:

E_{PPP} = \frac{P_{JP}}{P_{US}} = \frac{\text{¥}60,000}{\$500} = \text{¥}120/\$

According to absolute PPP, the theoretical exchange rate should be ¥120 for every $1.

Now, let's compare this to an actual market [exchange rate]. Suppose the current market rate is ¥140 per $1.

Interpretation: Since the actual market exchange rate (¥140/$) is higher than the calculated PPP rate (¥120/$), it suggests that the Japanese Yen is undervalued relative to the U.S. Dollar, or conversely, the U.S. Dollar is overvalued against the Yen based on the price of this specific good. In theory, a U.S. dollar buys more yen in the market than it "should" based on equivalent purchasing power. This indicates that the device is cheaper for a U.S. consumer to buy in Japan after currency conversion (¥60,000 / 140 ¥/$) = $428.57, which is less than $500. This could, theoretically, lead to [arbitrage] opportunities, driving the market rate closer to the PPP rate over time.

Practical Applications

While absolute purchasing power parity may not perfectly predict short-term [exchange rate] movements, it has several important practical applications, particularly in macroeconomic analysis and international comparisons.

International Economic Comparisons: PPP-adjusted figures are widely used by organizations like the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) to compare economic output, such as [gross domestic product (GDP)], and living standards across countries. This is beca⁴⁸, ⁴⁹use market exchange rates can be volatile and may not accurately reflect the real purchasing power within an economy, especially for non-traded goods and services which tend to be cheaper in lower-income countries. The OECD com⁴⁶, ⁴⁷piles extensive data on purchasing power parities for its member and partner countries, providing insights into relative [price level]s and economic well-being.
Identi⁴⁴, ⁴⁵fying Currency Over/Undervaluation: Absolute PPP can serve as a benchmark to identify whether a currency is theoretically overvalued or undervalued. Forex traders and investors may use these insights to form long-term views on currency movements, though short-term trading relies on many other factors. The Economis⁴³t's "Big Mac Index" is a well-known, albeit informal, example that uses the price of a standardized Big Mac burger across countries to illustrate PPP and currency valuation.
Cross-⁴¹, ⁴²Country Cost of Living Comparisons: Governments, multinational corporations, and individuals use PPP to compare the cost of living and adjust salaries or expatriate compensation to maintain consistent [purchasing power] across different locations. This helps in understanding the true value of income in different countries.

Limitati⁴⁰ons and Criticisms

Despite its foundational role in [international finance], absolute purchasing power parity faces significant limitations and criticisms, causing it to rarely hold true in its pure form.

Non-Tradable Goods and Services: A major drawback is that absolute PPP primarily considers tradable goods. However, many goods and services are not easily traded internationally, such as real estate, haircuts, and local services. The prices o³⁷, ³⁸, ³⁹f these non-tradable items can vary significantly between countries due to differences in labor costs, local regulations, and other factors, leading to deviations from PPP. For example,³⁶ labor costs in poorer countries are often lower, making non-traded services cheaper there.
Trade ³⁵Barriers and Frictions: The theory assumes no [trade barriers], transportation costs, or tariffs. In reality, these frictions introduce wedges between prices in different countries, preventing the [law of one price] from holding perfectly. Taxes, such ³², ³³, ³⁴as Value Added Tax (VAT), also contribute to price discrepancies.
Quality Differences: Absolute PPP assumes identical goods and services. However, the quality of seemingly similar products can vary across countries, making direct price comparisons challenging. Even a stand³¹ardized product like a Big Mac can have different local ingredients, production costs, or service environments, affecting its price.
Market³⁰ Imperfections and Capital Flows: The theory relies on the assumption of efficient markets and rapid [arbitrage] to correct price disparities. However, markets are not always perfectly efficient, and price adjustments can be slow. Furthermore,²⁹ the theory largely ignores [capital flows] and financial market factors, which can heavily influence [exchange rate]s in the short run, often outweighing the impact of goods prices.

Empirical e²⁷, ²⁸vidence generally shows that absolute PPP does not hold in the short run and deviations can be persistent, though some studies suggest it may hold over very long periods.

Absolute²⁴, ²⁵, ²⁶ Purchasing Power Parity vs. Relative Purchasing Power Parity

Absolute purchasing power parity is often contrasted with [relative purchasing power parity], which is a dynamic extension of the same underlying concept.

Feature	Absolute Purchasing Power Parity	Relative Purchasing Power Parity
Focus	Compares static [price level]s between two countries at a specific point in time.	Focuses on the rate of change in price levels (i.e., [inflation] rates) over time.
C²³ore Idea	The [exchange rate] should equal the ratio of the absolute price levels in two countries.	Changes i²¹, ²²n the exchange rate between two currencies should be proportional to the difference in their inflation rates.
Assump²⁰tion	Identical goods should cost the same in different countries when converted to a common currency.	Assumes th¹⁹at the real exchange rate (purchasing power) remains constant over time.
Realism	Less realistic in the short term due to numerous market frictions and non-tradable goods.	Often cons¹⁷, ¹⁸idered more realistic over the long term, as it accounts for ongoing inflation differentials.
Formul¹⁶a Components	Uses current price levels ((P_A), (P_B)).	Incorporates past exchange rates and current [inflation] rates. ¹⁵

While absolute PPP aims to establish the "correct" exchange rate based on current price levels, relative PPP predicts how the exchange rate changes over time in response to differing [inflation] rates. Relative PPP¹³, ¹⁴ implies that if absolute PPP holds, then relative PPP must also hold, but the reverse is not necessarily true.

FAQs

What is the simplest definition of absolute purchasing power parity?

Absolute purchasing power parity is an [economic theory] that states that the [exchange rate] between two countries should make an identical basket of goods and services cost the same in both countries when expressed in a common currency.

Why doe¹¹, ¹²s absolute PPP often not hold in the real world?

Absolute PPP often fails to hold perfectly due to factors like [transportation costs], [trade barriers] (e.g., tariffs and quotas), differences in the quality of goods, the existence of non-tradable goods and services (like local labor or real estate), and market imperfections that prevent immediate [arbitrage].

How is ⁹, ¹⁰absolute PPP different from the actual market exchange rate?

The actual market [exchange rate] is determined by a multitude of factors, including supply and demand for currencies, interest rate differentials, [capital flows], and speculative trading, in addition to goods prices. Absolute PPP⁷, ⁸, by contrast, provides a theoretical exchange rate based solely on the relative [price level]s of identical goods and services. The market rate can significantly deviate from the PPP rate, reflecting real-world complexities that the theory simplifies.

Can abs⁶olute PPP be used to predict future exchange rates?

While absolute PPP provides a long-term theoretical anchor for [currency valuation], it is generally not a reliable predictor of short-term [exchange rate] movements. Many other e⁴, ⁵conomic and financial factors influence exchange rates in the short run. However, persistent deviations from absolute PPP might suggest the direction of long-term currency adjustments.

What is the "Big Mac Index" and how does it relate to absolute PPP?

The "Big Mac Index," published by The Economist, is an informal and simplified application of absolute PPP. It compares ³the price of a McDonald's Big Mac in various countries to gauge whether currencies are overvalued or undervalued against the U.S. dollar, based on the idea that the burger should cost the same everywhere when prices are converted. While a ligh²thearted measure, it serves as a digestible illustration of the core concept of [purchasing power].¹