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Saturday, June 11, 2011

Purchasing power parity (PPP)

This theory says exchange rate of currencies between two nations should equal to the ratio of price level of fixed basket of goods and services.
Suppose that fixed basket of goods and services costs 100 CAD (Canadian dollar) in Canada and same basket costs 105 USD (US Dollar) in USA, then 1 CAD should equal to 1.05 USD.
As far as Present exchange rate is concerned, 1 CAD is equal to 1.02 USD.
Applying PPP theory, with perspective of basket under consideration, expects CAD to appreciate and USD to depreciation in future course of time.
So when a nation undergoes inflation (prices shall rise), we see exchange rate of its domestic currency must depreciate accordingly, to maintain equilibrium.
There are few factors due to which PPP concept gets defied, one of them is transportation cost and trade barriers.
 A products price also includes transportation costs and it may differ significantly in two countries.
Another point is there should be competitive market for goods and services in both countries.
It is important to know that the concept of PPP is applicable to only tradable goods between two countries and not for fixed assets like plants, warehouses etc.
Lets understand the this concept with a lucid example-
Robert Lafore’s book on C++ costs 40 $ (USD) in USA (Amazon price) while it costs ì 328 in India.
Present exchange rate is, 1 $=45 ì, this means price of the book in India is 7.3 $.
These shows how cheaper the book is in India. Provided legal permissions, it is much beneficial for US citizens to buy the book from India.
This was just an example to make the concept clear; actually PPP considers a pre-defined basket of goods and services.

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