Abstract

Table of Content
 Chapter 1: Introduction

1.1 Introduction:
Economics is the concept of social science which provides the analysis about distribution,
production and consumption of goods and services. Studies of economics enable the
economists, experts and other group of people who are associated with economics to
estimate the economic run of the country in terms of calculating the gross domestic
products. The economic growth of the country therefore is estimated through gross
domestic product. Purchasing power parity is a well known and very old concept in
economics which provided the comparison of price level in two or more countries for the
same product or services in their local currencies and ensure the purchasing power of
consumers or the nationals of the particular country over the population of other
countries. It is a broader concept to understand the differences of income and expenditure
among the countries. As per the law of one price, the selling price of identical goods in
two different countries should be same at a given point of time. This concept has
developed the theory of purchasing power parity which relates to the exchange rate with
the price levels. Within the purchasing power parity, there are two different concepts
known as absolute purchasing power parity and relative purchasing power parity.
Therefore to understand the broader picture of economic concept this research study
focuses towards the purchasing power parity in developed and developing countries. The
research also focuses on determining the factors which influences the purchasing power
parity between the countries and how it is calculated while deciding on the PPP. This
chapter provides the brief introduction of the research including the aims and objectives,
significance of the research, rationale behind the research, structure of the research report
and summary of the chapter.

1.2 Research Aims and Objectives:

Purchasing power parity enables the economists and researcher to understand the
purchasing power of the population to buy a product and hence one of the big deciding
factor of consumer living index within the countries. Purchasing power parity calculates
the equilibrium exchange rate of prices between the two countries. The aim of the project
is to analyze the purchasing power parity between countries like U.S, U.K & India. The
thesis would contain the different factors influencing the PPP between different countries
and how is PPP calculated and considered while deciding on the PPP. In order to achieve
the aim of the research, the following research objectives will be achieved in this study.

• RO1: What is Purchasing power Parity?

• RO2: How is PPP calculated
• RO3: Law of one price theory
• RO4: What is relative PPP & absolute PPP
• RO5: Effect of PPP on exchange rate between different countries.

1.3 Significance of the Research:

In management studies, economics has its prime importance since it gives the sense to the
managers to understand the various economic and social factors while preparing the
business strategy. In case a company is going to enter in foreign country then it is
essential to understand the purchasing power in that particular country so that the
marketing manager can decide on the price at which the product should be sold in the
country. While analyzing these factors, it is essential to have knowledge of various
economic concepts such one price law theory, purchasing power parity and impact of
PPP on exchange rate between the countries. By conducting this research, the researcher
is able to grab the deeper insights on such economic concepts. Also the research
contributes the studies of economics in the management field to provide the clarity in the
concepts of purchasing power parity so that the other students can take the advantage of
it.

1.4 Rationale behind the Research:

The rationale behind the research is to get the clear understanding of purchasing power
parity which is essential to determine the power of the consumers in purchasing the
products in different countries. The study will help the researcher in his future endeavor
to get the job opportunity in the field of strategic consultant. For a strategic consultant,
understanding of economic concepts is important since his job responsibilities not only
cover in preparing the domestic market strategy but also the international market strategy.
Hence the research has been conducted to ensure the strength and better understanding of
concept of one price law theory and purchasing power parity.

1.5 Structure of the Report:

A well structured research report attracts the reader to read each and every chapter so that
he can understand the aims and objectives of the research and how it has been achieved.
Also a systematic alignment of the research report provides the understanding to the
researcher itself to rationalize the every part of the research step by step. With this view
the over all research report has been divided into 5 chapters. First chapter provides the
brief introduction of the research. Second chapter provides the literature review which
includes detailed discussion on the views of different authors towards purchasing power
parity and associated economic concepts. Third chapter includes the research
methodology description which is used by the researcher to conduct this research work.
Fourth chapter includes the detailed analysis and findings of the research. Fifth and last
chapter includes conclusion drawn by the researcher from findings of the research and
provided the recommendation.

1.6 Chapter Summary:

The research has been conducted to understand the concept of purchasing power parity
which will help the researcher in his career and job opportunity in the field of
management and consultancy. This chapter provides the brief introduction of the research
including the aims and objectives and contribution of the research towards the studies of
economics and management. The research also focuses on determining the factors which
influences the purchasing power parity between the countries and how it is calculated
while deciding on the PPP. Finally the chapter includes the structure of the research
report since it is essential to understand what each chapter in the report includes so that
the interest among the readers can be developed.
 Chapter 2: Literature Review

2.1 Introduction:
Literature review in the research plays an important role since it enable the researcher to
understand the view of different authors provided in the context of research theme. The
research is focusing towards the concept of purchasing power parity analysis in different
countries. This chapter includes detailed discussion of various authors towards
purchasing power parity and provided the deeper insight of economics.

2.2 Purchasing Power Parity - A Concept:

In current globalization era, the goods, products, services, finance, labor and ideas need
to compare and measure the living standards in one country as it is essential to
understand for the business purpose as well. In case a company is going to enter into new
market then it is an essential point for the company to understand the cost of labor and
production for producing the same goods and services in the foreign country other than
the domestic country. The production of goods and services therefore showcase the living
standards and important for various individuals such as investors, potential immigrants,
traders and business professionals to understand their value of money in foreign country
other than host country. In comparing the value of money for a potential individual then,
it is been assessed in terms of purchasing the goods and products in two different
countries. The difference in rate in these two countries is known as exchange rates with
which an individual can calculate the value of a particular product in both the countries.
Such an exchange rate is used in converting the current value of currency in to currency
of other country. Exchange rates sometimes ignore the domestic economic sectors in
which the prices of the commodities are fixed in the absence of consultation from other
countries. In this manner the exchange rates actually does not reveal the real volume of
the output of goods or service which has been bought by an individual. The difference of
real prices of goods and service between the two or more countries needs to be measured
in one common scale. Here comes the role of purchasing power parity which enables the
individual to convert the local currencies into one common currency and ease the
comparison of purchase prices of the same product or service in two different currencies.
Purchasing power parity is a methodology which provides the way of measuring the
effectiveness of busying power of an individual in two or more countries at a given point
of time. However in ideal efficient market it has been stated that the identical goods or
services are sold at same prices and this is known as one price law theory. A detailed
discussion for one price law theory has been presented later in this chapter. US dollar is
the common currency across the world. The purchasing power parity is then calculated in
one single currency such as USD. In the current competitive business environment and
regular fluctuation in the economy has increased wide variation in the prices across the
countries which needs a common concept to ensure that the common currency can be
used to convert the prices of goods and services. A large difference cab identified for the
goods and services which are traded internationally and sold only into the local markets.
Also the difference can be identified in the cost of labor, cost of production, housing cost
and healthcare services. A common service which is not served at international level is
haircut. This is more expensive in US as compared to India due to which the haircuts in
India are very frequent. Due to the low cost of production and labor cost, most of the
foreign companies are setting up their manufacturing unit in India and other nations as
like India. Due to the purchasing power parity, the off shoring in globalize environment
become possible. Purchasing power party is therefore a best method of comparing the
living standards between two countries. The purchasing power factor of India as
compared to US is 16.735 in 2007 as per the data provided by United Nations Statistics
Division (UNSD). Purchasing power parity can be defined as the number of units
required to convert currency of one country to currency of another country for purchasing
same goods and services within their local markets. For example if an individual spend
INR 45 in US to buy a particular product then the person needs to spend Rs 16.50 for the
same product in India. It signifies that the same product or service in India is three times
cheaper than US. According to the International comparison program conducted by
World Bank in 2005, the individual household expenditure was USD $1,183 in India
while it was $29,368 in US for the same amount of product and services used. Food
consumption expenditure in India was USD 318 however for the same amount of food;
the consumption expenditure in US was 1,998. If comparing the health expenditure, then
the spending by Indian household was USD 485 while it was 5856 in US for the same
services. The standard definition of Purchasing power parity is given below:

“A theoretical aspect of purchasing power parity is defined as theory of exchange rate

between the two currencies which establish the equilibrium when the purchasing power
of a particular product is same in both the countries. It signifies that the exchange rate
between the two countries should be calculated in the same ratio to determine the price
level of a fixed quantity of similar type of goods and services. If the domestic level price
in the country is increasing then it signifies the high rate of inflation and directly impact
on the exchange rate which means the exchange rates depreciated in order to return the
purchasing power parity. Purchasing power parity is used to calculate the standard of
living”.

As mentioned earlier the concept of purchasing power parity is solely depends on the law
of one price theory which stated that the price of the identical goods should be same in
the absence of local taxes, shipping and freight charges and distribution margin in tow
different countries. The difference in the prices should be less for the goods and services
which are traded at international level and markets as such electronic goods, equipment
and machinery. For countries like India the theory of purchasing power parity may nit
work in India due to the high inflation rate as the electronic goods and automotive in
India is much more expensive that US. Further to understand the concept of purchasing
power parity, it would be essential to understand the law of one price theory as discussed
in the following section.

2.3 The law of One Price Theory:

The law of one price theory is validated by positive information cost in which the
commodities which are most commonly traded at international markets needs to include
the explicit contractual component with objective measurement which is enforced by the
state. On the other hand this must include the implicit contractual component with
subjective measurement which is enforced by the reputation. In such a manner, the
costless information yields with the law of one price theory along with the competition in
the market. It provided the discretion to the seller for setting up the prices and population
expectations diverted to the equilibrium prices. However in the conjunction of hedonic
model, the costless information implied the monopolistic competition governed by the
law of one price theory. On the other way round the costly information includes the
inconsistency in the perfectly competitive market and restore the price discretion towards
the monopolistic competition. However as per the studies of purchasing power parity and
law of one price theory, the empirical work needs to reject such assumption and the real
prices did not diverge which tend to overlook commodities components. As much as the
information of the product quality increases the price variation of a particular commodity
will decline. The cost of commodity information may fall in the cost of using such
information and subsequently following the effects. A bigger transition in the shift from
the attributes of reputation components agreements the contractual components and
uncertainty about the make up of commodities which will decline in the price compilers
with the observed price variability and complete a more accurate job. The first assertion
towards the similarity in prices for identical goods was identified by Cournot ([1838]
1927, p. 51). Tiding up this relationship with the market, the author stated that the market
is entirely depending on the relationship of unrestricted commerce which brings in the
price consideration towards the rapidity and ease. According to author 2, in a perfect
market, the stronger tendency for the same prices of goods is paid at the same time in all
the markets. In the simplest form it has been argued that the law of one price theory is
confined at one point of time is a single space. With the similar thoughts, expense of
delivering the goods generally not considered under the exchange rate consideration. The
law of one price theory therefore is applicable only for the combination of commodities
and should not includes the shipping and freight cost. This concept is useful for
expanding the domain from the areas of competition. An assumption has been made to
understand the exchange rates which are subject to the law constitution based on the
purchasing power parity. The commodity attributes are also considered as the
combination which is also implemented on laws. According to the author3, there is no
uniformity in prices of product and services in different countries. Further to elaborate,
there is a tendency for strong products/commodities such as gold and government bonds
which are homogenous in nature and can be recognized easily in each country. all those
things which are in universal demand and capable enough to be exactly described and
easily recognized are subject to the tendency of getting the difference of prices of the
products. The law of one price theory is strong for the homogeneous products or
commodities. The findings of author4 supported such notion. The primary argument for
such differences is the qualification in transportation cost which needs to be flawed and
these authors stated that the law of one price theory is perfectly competitive markets in
which the knowledge is perfectly distributed. The perfect knowledge in market
competitiveness is essential and important aspect for the business to meet the sufficient
condition of law of one price theory. Using the concept of perfect knowledge, the sellers
and buyers in the market are received the information at no additional cost related to the
quality of the product and bring in the prices down instantly. As much as the individuals
are intended to trade in highly competitive markets, the law of one price theory needs to
be succeeding under price discrimination. Under monopolistic conditions within a
country, one price attributes of product and services must be prevailed. On the other hand
these prices are expected to be diverged from the information which is costly in respect to
the product. In such sense there is a notion for the individuals to diverge the cost of the
product due to the costly information however the literature associated with law of one
price theory and purchasing power parity does not accept this statement. Author5 was the
first researcher who had researched out in this context. In the state of competitive
equilibrium, the price consideration is incapable to restoring it. Author6 stated that in the
state of equilibrium the prices are diverged since the individuals used their local market
power to diverge the prices. On the other hand author7 constructed the model in which
they have suggested that if the seller and buyer bargains with each other then they will
definitely come at the price where the buyer is ready to pay and seller is ready to sell.
This must be possible even in the stage of equilibrium. Author 8 stated that the
divergence in the prices can also be occurred due to the differences in the quality of
products, though these authors’ focuses towards the cost of information search with
which the divergence in the prices of product is occurred even in the state of equilibrium.
It is therefore recognized as the prices will not diverge even if the information would be
freely available.
2.4 Purchasing Power Parity and the Long Run:
According to the theory of purchasing power parity the difference in the pricing of two
different commodities are not sustainable in the long run since the available market
forces equalize the price between the countries and also changes the exchange rate for
completing it. There is a special case example can be cited to understand the purchasing
power parity. For example if the prices of base ball bat is USD 40, in USA and the same
bat is available in Mexico at 150 peso per unit. Now the exchange rate between US and
Mexico is, USD 1 = 10 peso. There is a clear benefit of purchasing the bat in Mexico
since the bat will be available at $15 in Mexico while the same bat will cost about $40 in
USA. In this example where the consumers are crossing the boarder for buying the base
ball bat may be un realistic since the expense of linger trip would wipe out the savings
from the market and purchasing the bat at lower prices from the market. However this
example will be realistic in case a company purchase 100 bats and bring them in USA
though shipping to sell them or for the retail giant like Wal-Mart who can purchase the
bat at much cheaper prices from the Mexican manufacturer and sell them in US market.
the price differential between the Mexico and US prices will not be substantial in the long
run since the individual or the company will not be able to get the an arbitrage profit after
buying such products and sell them in the market at a higher prices. Prices of a product
may not be equal across the markets therefore the prices or the basket of goods in a
combination must be equalized. However this is a theoretical concept and may not be true
in practice. There are certain factors which limit the free trading of goods across the
countries and also limit the opportunities for the people who can have the advantage of
arbitrage this opportunity. These limitations are listed below:

2.4.1 Import and Export Restrictions:

In import or export of products there are the some limitations in both the countries such
as quotas, tariffs and laws which makes the trade difficult to buy certain goods in one
market and sell them into other markets. for example if the tax on import in USA will be
300% then purchasing the baseball bat from the Mexican manufacturer will not make
any since the buyer will have to pay $45 for one bat and the total cost of purchasing one
bat will be $60. Instead of purchasing the bat from Mexico and sell those in the US
market will not be profitable rather purchasing it from the US manufacture and sell them
in the domestic market.

2.4.2 Travel Costs:

If in case the logistic and transportation cost of goods in much more expensive than it
does not make any sense to purchase the foods from foreign country and sell them in the
domestic market. it is also possible within the country or the countries where the
exchange rate is equal. For example the price of a particular product may be cheap in
cities like Toronto and Edmonton however it is most expensive in Nunavut and some
other parts of Canada.

2.4.3 Perishable Goods:

Sometimes it is difficult to transfer the goods from one market to another market
physically since there are the places where the same goods are sold at lower prices due to
low material cost and in some places the goods are sold at much higher prices due to high
material cost. Also if some goods such as sandwiches are sold at lower price in New
York and higher is San Francisco due to low or high material costs. Now if the seller will
try to transfer the good from New York to San Francisco them obviously the sandwich
will be rotten. This example is based on the famous economic concept known as Big Mac
Index.

2.4.4 Location:
Location is another barrier which can be understood better through example of real estate.
Since the prices of property is not same everywhere therefore the difference in prices for
land will be wide. It must have an impact on the retailers where the price are cheap than
the retailers where the land prices are higher. After studying the concept of purchasing
power parity it has been determined that the theory of purchasing power parity predicts
that the exchange rates are not sustainable in the long run.
2.5 Purchasing Power Parity in Short Run:
In the short run the exchange rates are not driven by any event or news therefore the
exchange rate under purchasing power parity is sustainable in the short run. If there is any
announcement about the economies growth or the interest rates then, these factors will
not have any impact on short run. The long run behavior of the exchange rates can be
described through purchasing power parity comparison. The force of economics behind
the purchasing power parity will finally tend to equates the purchasing power of
currencies and it would take long period of time.

2.6 Purchasing Power Parity Calculation:

The simplest way to calculate purchasing power parity between two countries is to
compare the price of a "standard" good that is in fact identical across countries. Every
year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger
Index" that compares the price of a McDonald's hamburger around the world. More
sophisticated versions of PPP look at a large number of goods and services. One of the
key problems is that people in different countries consumer very different sets of goods
and services, making it difficult to compare the purchasing power between countries.

S (purchase power parity ratio) = Price 1/Price 2

In this case, P1 refers to one price in a specific currency, and P2 refers to another price in
a different currency. For instance, suppose you want to calculate the purchasing price
parity between the United States and Mexico. Your comparison prices will be in U.S.
dollars and Mexican pesos. Determine which product is commonly available in both the
United States and Mexico. For simplicity, we'll compare the price of Coca Cola in both
countries. Although comparing one common product is one strategy, economic analysts
may also select a group of common products to calculate a more broad measure of
purchasing power parity. This group of products is commonly called a basket of goods
and may include food staples such as bread, milk and other related items. Although the
basket approach may be broader, the single item method helps illustrate the calculation in
simpler terms. Research the prices of Coca Cola in Mexico and the United States. The
purchasing power parity formula requires you to know the price of the item you are
comparing. Assume for this example that a 12-ounce can of Coca Cola costs $1.50 in
U.S. dollars and $9 Mexican pesos. Divide the $9 pesos by $1.50. The result is the price
ratio for purchasing power parity. To illustrate the calculation refer to the following:

S = P1/P2
S = 9/1.50
S=6
Compare the result of the purchasing power parity to the currency exchange rate between
the United States and Mexico. Assume that the exchange rate between the Mexican peso
and U.S. dollar is 5.7 pesos for every dollar. Recall that for purchasing power parity to
exist, the exchange rate and the purchasing power parity ratio must be equal. The
purchasing power parity ratio of 6 and a $5.7 peso per dollar exchange rate between the
currencies in Mexico and the United States indicates that the purchasing power of the
peso and the dollar are similar but not exact. This means that Mexican and U.S.
consumers have similar purchasing power with their respective currencies.

2.7 Chapter Summary:

This chapter includes detailed discussion of various authors towards purchasing power
parity and provided the deeper insight of economics. In comparing the value of money
for a potential individual then, it is been assessed in terms of purchasing the goods and
products in two different countries. The difference in rate in these two countries is known
as exchange rates with which an individual can calculate the value of a particular product
in both the countries. Such an exchange rate is used in converting the current value of
currency in to currency of other country. . If the domestic level price in the country is
increasing then it signifies the high rate of inflation and directly impact on the exchange
rate which means the exchange rates depreciated in order to return the purchasing power
parity. The cost of commodity information may fall in the cost of using such information
and subsequently following the effects. A bigger transition in the shift from the attributes
of reputation components agreements the contractual components and uncertainty about
the make up of commodities which will decline in the price compilers with the observed
price variability and complete a more accurate job. Under monopolistic conditions within
a country, one price attributes of product and services must be prevailed. On the other
hand these prices are expected to be diverged from the information which is costly in
respect to the product. In such sense there is a notion for the individuals to diverge the
cost of the product due to the costly information however the literature associated with
law of one price theory and purchasing power parity does not accept this statement.
 Chapter 3: Research Methodology

3.1 Introduction:
Research methodology is an essential part for conducting a research therefore needs to be
described in detail to develop the clear understanding of various methods and available
and which method has been used by the researcher. This chapter therefore includes the
detailed description of research methodology that has been used by the researcher for
conducting this research study.

3.2 Research Design:

According to Saunders et al, 2005, a research design is a process of collecting and
analyzing data in a systematic manner to achieve the set goals and objectives. The
philosophy which was developed by Saunders et al, 2005 was a research process to
dominate the literature interpretivism. As the human behavior keeps changing, the same
is the case with conclusion for different study. As the study is on the purchasing power
parity between counties, the study would be in depth reality (Saunders et al, 2003
Jankowicz 2005). According to Daymon and Holloway 2002, the best approach for a
qualitative research is interpretivist. The research would be qualitative research where I
would be collect a lot of data and apply various statistical tests.

3.3 Data Collection:

arious tools would be used to collect data for the research. The major tool would be
through secondary research. I would collect data from various research companies’
reports, journals, government sites of countries and research engines like crisinfac,
Factiva, ProQuest, Eui.com etc. these research tools would give us enough data for
different countries for comparison and for analysis (Aaker, D, A, Kumar, V, Day, G, S;
1999). The sample would be for 4-5 countries of which 3 would be US, UK and India and
the rest two would be developed countries depending on data available. There would be a
little primary research to the extent of interview with some of the economist. This would
help the researcher to understand the steps to cover and the data to be collected for the
analysis. So the data collection would be from both, primary and secondary, thou major
part of the data collection would be through secondary research. According to Weiers
R.M 1988, an interview method of collecting data puts the respondents to give accurate
answers and to avoid bias. Also helps in getting maximum information from the
respondent.

3.4 Reliability and Validity of the Research:

According to Bryman 2004, reliability required that the finding of two researches should
be similar or supportive to the research if done earlier. As the research is exploratory, the
research would be developed and the process would be predefined. Allowing researcher
to get an in-depth response and reveal better results. Validity on the other hand stands for
comparing the results of the research finding to the set aim and objective and compare if
they both match (Weiers 1988). The research would be valid as the research involves data
from research sites which are trusted and reliable (Kotler P, Keller K.L., Koshy A., Jha
M. (2007)).

3.5 Data Analysis:

The data analysis would through different statistical tools and would be represented in
graphical and tabular form. The collected data would be used in different calculation of
Purchasing power parity theory and models. And the outcome would be presented in the
form of table and graph for comparing the countries changes or similarities.

3.6 Research Limitations:

The major limitation that would be faced while doing the research would be the tight
dead line and limited finance. As the set process and timelines would be predefined, the
timelines would allow us to work fast and hard to get to the result in the specified
timelines. Also collecting data and getting an appointment from the economist for
interview would be the fire facing challenge. As the researcher is a student, the finance
was not supported to an great extend for lavish spending for getting the data collected. It
was managed with efficiency and enough cash was reserve.
 Chapter 4: Findings and Analysis

There have been many empirical tests of PPP in the last four decades and an enormous
evolution of the proper underlying procedures for these tests. This section gives a brief
overview of the empirical findings; see Sarno and Taylor (2002, ch. 3) for an excellent
and more detailed review. Early empirical tests of PPP (until the late 1970s) were
essentially directly based on equation. More specifically, one would estimate the
equation.

A test of the hypothesis would be interpreted as a test of absolute PPP. Using this test for
first differences in equation, that is replace by st_1_st, etc., would be interpreted as a test
of relative PPP. In general, this early literature, which did not use dynamics to distinguish
between short-run and long-run effects, rejected the PPP hypothesis. A clear exception is
the influential study by Frenkel (1978), who analyses high-inflation countries and gets
parameter estimates very close to the PPP values, suggesting that PPP holds in the long
run. As it turns out, there are many econometric problems associated with the early
testing procedure. An economic issue is the so-called endogeneity problem, referring to
the fact that in equation it is not simply prices that determine exchange rates, but both
prices and exchange rates are determined simultaneously in a larger economic system.5
The most important problem is, however, purely technical (that is: econometric) in
nature. See Granger and Newbold (1974) and Engle and Granger (1987) for so-called co
integration and stationary problems.

The early studies of the next generation of tests addressing the econometric problems of
PPP testing were rather mixed in their support for PPP; see for example Taylor (1988)
and Taylor and McMahon (1988). Once it was realized that these early co integration
studies, which tended to focus on rather short time periods, had very low power of the
tests, that is, low precision with which definite conclusions could be drawn, it was clear
that one final econometric problem had to be overcome. Two methods were devised to
address this power problem, namely analyzing really long time series data and analyzing
panel data. Both methods generally support long-run (relative) PPP. As the name
suggests, the really long time series method extends the period of observation, which
introduces an exchange rate regime-switching problem (from gold standard to Bretton
Woods to floating exchange rates; that the exchange rate may behave differently under
different regimes, which is an issue that must be addressed by an econometrician).

Country PWT Big Mac index

India 66 100
US 75 61
Brazil 45 66
Britain (UK) 98 120
Mexico 61 88

Figure 4.1 PWT Vs Big Mac index

Frankel (1986) analyses dollar–sterling data from 1869 to 1984. See also Edison (1987),
Glen (1992), and Cheung and Lai (1994). Panel data studies avoid the regime-switching
problem by focusing on a short time period of analysis (usually the more recent floating
exchange rates), but combine evidence from many different countries simultaneously in
one test. The most powerful test used in Taylor and Sarno (1998), for example, provides
evidence supporting long-run PPP during the recent float period.
Structural deviations: PPP corrections
The above discussion focused on the empirical validity of relative long-run PPP. A
related problem is the phenomenon of PPP corrections. The correction problem focuses
on the fact that there is a consistent bias in real income measures for different countries
when the nominal exchange rate is used as a basis for comparison. As such, it argues that
there is a consistent bias in absolute PPP deviations. As mentioned earlier, the argument
is based on the distinction between traded and non-traded goods. It goes back to Harrod
(1933), Balassa (1964), and Samuelson (1964), and is therefore known as the Harrod–
Balassa–Samuelson effect. The effect plays a role in policy discussions for new entrants
to the European Union. The ranking of production value using current US dollars that is
converted at the going exchange rate is deceptive because it tends to overestimate
production in the high-income countries relative to the low-income countries. To
understand this we have to distinguish between tradable and non-tradable goods and
services. As the name suggests, tradable goods and services can be transported or
provided in another country, perhaps with some difficulty and at some costs. In principle,
therefore, the providers of tradable goods in different countries compete with one another
fairly directly, implying that the prices of such goods are related and can be compared
effectively on the basis of observed (average) exchange rates. In contrast, non-tradable
goods and services have to be provided locally and do not compete with international
providers.
Fig: 4.2 Purchasing Power Parity in India

Fig: 4.2 Purchasing Power Parity in US

Fig: 4.2 Purchasing Power Parity in Brazil

Fig: 4.2 Purchasing Power Parity in UK

 Fig: 4.2 Purchasing Power Parity in Mexico

Think, for example, of housing services, getting a haircut, or going to the cinema. Since
(i) different sectors in the same country compete for the same labourers, such that (ii) the
wage rate in an economy reflects the average productivity of a nation, and (iii)
productivity differences between nations in the non-tradable sectors tend to be smaller
than in the tradable sectors, converting the value of output in the non-tradable sectors on
the basis of observed exchange rates tends to underestimate the value of production in
these sectors for the low-income countries. For example, on the basis of observed
exchange rates, getting a haircut in the USA may cost you $10 rather than the $1 you pay
in Tanzania, while going to the cinema in Sweden may cost you $8 rather than the $2 you
pay in Jakarta, Indonesia. In these examples the value of production in the high income
countries relative to the low-income countries is overestimated by a factor of 10 and 4,
respectively. To correct for these differences, the United Nations International
Comparison Project (ICP) collects data on the prices of goods and services for virtually
all countries in the world and calculates ‘purchasing power parity’ (PPP) exchange rates,
which better reflect the value of goods and services that can be purchased in a country for
a given amount of dollars. Reporting PPP GNP levels therefore gives a better estimate of
the actual value of production in a country. Figure 20.10 illustrates the impact on the
estimated value of production after correction for purchasing power by comparing it to
the equivalent value in current dollars. The USA is still the largest economy, but now
‘only’ produces 21.4 per cent of world output, rather than 30.3 per cent. The estimated
value of production for the low-income countries is much higher than before. The relative
production of China (ranked second) is more than three times as high as before (rising
from 3.9 per cent to 12.5 per cent), and similarly for India (rising from 1.6 per cent to 6.0
per cent), Russia (rising from 1.2 per cent to 2.5 per cent), and Indonesia (rising from 0.5
per cent to 1.3 per cent). The drop in the estimated value of output is particularly large for
Japan (falling from 12.0 per cent to 7.1 per cent), reflecting the high costs of living in
Japan. Of course, when estimating the importance of an economy for world trade or
capital flows, it is more appropriate to use the actual exchange rates on which these
transactions are based, rather than PPP exchange rates.

Chapter Summary:
If there are no impediments whatsoever to international arbitrage, an identical good
should sell for the same price in two different countries at the same time. This absolute
version of the Law of One Price for individual goods can be used to derive a relative
version of the Law of One Price (focusing on changes rather than levels) and a (relative
and absolute) version relating exchange rates and price indices, referred to as purchasing
power parity (PPP). The derivation is based on assumptions which, if they do not hold
exactly, can cause deviations from PPP. The most important causes of such deviations are
transaction costs, composition issues (the way in which indices are constructed), and the
existence of differentiated goods, fixed investments, thresholds, and non-traded goods.
Empirical studies do, indeed, find substantial and prolonged short-run deviations from
relative PPP as measured by real effective exchange rates. In the long run, however,
relative PPP holds remarkably well, certainly in view of the strict assumptions necessary
for deriving PPP. The majority of the remaining chapters will focus on structural models
invoking long-run (relative) PPP. There is, therefore, a bias in our analysis to try to
understand the long-run equilibrium implications of economic policies and developments.
It should be noted, finally, that there is a structural bias in deviations from absolute PPP
based on observed differences between countries of traded relative to non-traded goods.

Chapter 5: Conclusion and Recommendation

The indicators of price competitiveness described up to now do not allow any

conclusions to be drawn about a country’s competitiveness in accordance with absolute
purchasing power parity theory. This is because price or cost indices, which ultimately do
not allow any insight into the appropriate relative price and cost levels, were used to
calculate these indicators. An evaluation of competitiveness based on the absolute
purchasing power parity theory, however, calls for appropriate level comparisons. The
relative price levels for the very broad baskets of goods – which are geared to gross
domestic product (GDP) – of the OECD members and other European countries, are
provided by the OECD-Eurostat “Purchasing Power Parity Program.” The World Bank,
for example, makes available data for a larger group of countries based on the findings of
the “International Comparison Program”. In recording prices, these projects consider both
the representative ness and the international comparability of the goods and services. It
may at first not seem particularly suitable to use such broad baskets of goods for
comparisons of price competitiveness as it can be assumed that a relatively high
percentage of – in particular – the services in these baskets of goods are not traded
internationally and are thus not directly exposed to international competition. However,
as in the case of using deflators of total sales, an argument in favour of broad baskets of
goods is that goods which are not traded internationally are employed in the production
of tradable goods and that the corresponding relative price levels thus reflect fairly well
the general domestic cost pressures to which enterprises are exposed. The composition of
the basket of goods has quite a big effect on the findings with regard to relative
competitiveness. A basket of goods which gives a fair reflection of domestic
consumption habits but not foreign consumption habits will tend to show a lower
domestic price level and thus overestimate any domestic competitive advantages. In order
to eliminate such bias, the Eurostat price data used here are for a basket of goods which is
typical – at least to a similar extent – for all of the countries examined.5 It is possible to
get an idea of the robustness of the findings with regard to the choice of basket by
comparing the relative price level calculated using the Eurostat data with the relative
price level calculated using the Federal Statistical Office’s price data which are, however,
based on the German basket of goods owing to a different objective.6 At the beginning of
2004, the price of the German basket of goods calculated in this way was one-eighth
lower than on a weighted average against the 19 trading partners considered. This shows
that, even when absolute purchasing power parity is used to assess competitiveness,
allowances must be made for a margin of uncertainty. The analysis can also be extended
from a purely cross-sectional view to take account of the time dimension. Although the
real exchange rate and the measure of productivity used turn out to be integrated and co-
integrated if panel integration and co integration tests are applied – which, in principle,
suggests a Balassa-Samuelson effect –, three different panel estimation methods provide
quite disparate estimates of the suggested connection. Another condition for the law of
one price to generalize to PPP is that weights assigned to the goods in the price indices
must be the same across countries. Usually, these weights are based on actual
consumption or production shares. So, for example, if more lettuce per capita is
consumed in the United States and more pickles per capita are consumed in Britain, then
the price of lettuce will be relatively more important in a U.S. price index, whereas the
price of pickles will be more important in a British index. Even if lettuce and pickle
prices are always identical in the two countries, a rise in the world price of pickles will
have a larger impact on the British price index than on the U.S. index. Most studies of
PPP, therefore, are based on relative PPP, which does not require either the same basket
of goods or the same weights applied to these goods in the price index. This relative
version of PPP states that changes in price levels will be related to changes in exchange
rates. As a long-run test, relative PPP is somewhat difficult to evaluate for the Big Mac
because data are limited for many countries and there are only a few years of
observations. The data suggest, however, that PPP does not generally hold in the short
run, for either the absolute or the relative versions of the theory. Furthermore, for many
currencies, deviations from PPP against the U.S. dollar appear to be sustained over a
period of several years. The next section provides some explanations for these deviations
from PPP.

The inclusion of non-traded goods in price indices is often considered the primary
explanation for deviations from PPP. This is because, in the absence of barriers to trade,
which for most goods are not substantial, the law of one price states that the price of
tradable goods will be the same in all countries. Another fundamental requirement for
PPP to hold is that markets are perfectly competitive. If imperfect competition exists—so
that firms have market power—then even in the absence of barriers to trade, goods prices
may not be equal across countries. Some economists have argued that differences in
tradable goods prices account for much of the deviation from PPP. Differences in traded
goods prices across countries can occur if firms are able to price to market—
that is, charge different prices in different countries. Economic theory states that a firm
will maximize profits by varying prices in accordance with the elasticity of demand for a
product. The elasticity of demand indicates how the quantity demanded of a product
changes when the price changes. If the price of a good increases by 10 percent and the
quantity demanded falls by less than 10 percent, the demand for this product is said to be
inelastic. If the price increases by 10 percent and the quantity demanded falls by more
than 10 percent, the demand for this product is elastic. Sales revenue rises following an
increase in the price of a good whose demand is inelastic and falls following an increase
in the price of a product whose demand is elastic. A firm would be able to maximize
revenue, and hence profits, by pricing to market—charging a higher price for its product
in a country where demand is inelastic relative to a country where demand is more
elastic. Firms that price to market in international markets may limit exchange rate pass-
through— the extent to which changes in the exchange rate result in changes in import
prices. If exchange rate pass-through was complete, the 14 percent rise in the Australian
dollar against the U.S. dollar between 2002 and 2003 should have resulted in a 14 percent
decline in the price of Australian beef sold in the United States. Incomplete exchange rate
pass through means that the price of imported goods does not rise (fall) by as much as the
rise (fall) in the value of the foreign currency. When exchange rate pass-through is
incomplete, then a wedge occurs between the prices of a good in the domestic and foreign
markets, expressed in a common currency. In countries where demand is relatively
elastic, a firm may limit pass-through to maintain market share when the local currency
depreciates and to increase its profit margin when the local currency appreciates.
The ability of a firm to price to market depends on the ease with which goods can be
resold across countries. For example, because of differences in safety and pollution
standards, as well as warranty restrictions, it is difficult for individuals to resell
automobiles across borders.