Purchasing Power Parity

Purchasing power parity is a ratio of two currencies, based on the value of similar goods in different countries.

We can assume that a certain standard set of goods in the United States costs $ 25, and in Russia 500 rubles. In this case, if we take as a basis the purchasing power parity, then it is fair to say that if we divide 500 by 25, we will get a rate of 20 rubles per 1 dollar. If there are differences in quotes in one direction or another, traders will be able to sell goods in another country, while receiving a certain profit. At the rate, for example, 30 rubles per dollar, on each unit of goods you can earn 10 rubles. The result of this should be one of two options: either a comparison of prices for goods, or a change in the exchange rate.

In order to fulfill this economic model, in practice, a number of conditions must be met. To begin with, it is a question of the fact that costs for moving goods from one country to another should be as small as possible: the absence of customs duties, the lowest transportation cost, and many other parameters. Another prerequisite is the free conversion of currencies into each other, that is, there should be an opportunity to exchange them for each other in any amount, while there should be no exchange controls, state regulation or other obstacles. We can say that ideal trading conditions are extremely rare, so there is no sense in practice to use purchasing power parity, it serves only as a common reference, that is, the direction of changing quotations in the future.

The hypothesis, which is based on the parity indicator, connects the dynamics of the exchange rate with the change in the price ratio in the respective states. All this theory is based on the fact that international trade makes it possible to smooth out the difference in the price movement of the main types of goods in world trade. The cost of such in different countries should be approximately the same, and it should be expressed in one particular currency. It is quite obvious that such a price equalization mechanism can not act on all services and goods. With all this, the theory of purchasing power parity has empirical confirmation. It works by being very useful in analyzing exchange rates and prices in countries where inflation is quite high. In the conditions of hyperinflation, there is almost complete coincidence of domestic prices with the exchange rates of national currencies. It is important to understand that the correlation between the dynamics of exchange rates and the correlation of inflation levels in different countries exists in the long term.

Purchasing power parity and the theory based on it do not find enough evidence in the short term, especially in countries where inflation is low. The weighted average price ratio, which is calculated on the basis of different commodity baskets in two countries, may not correspond to the level of the exchange rate for a number of years, as well as its dynamics. However, the confirmation of this theory in the long run is sufficient to talk about such a factor influencing the exchange rates as the trade balance of the country, that is, the relationship between the trade balance and the dynamics of the exchange rate.

There is also such a thing as currency parity. It is related to the relationship between the two currencies, which is usually established in the manner prescribed in the legislation. Earlier this indicator was based on the gold reserve of the country, and now it is based on a slightly different information.

If we talk about where these indicators are used, then we can say that they are very useful for calculating GDP at purchasing power parity. Thanks to him, you can more accurately compare the economy of two different countries.