What Is Absolute Purchasing Power Parity?

Absolute purchasing power parity holds that the value of a country's currency and its demand are determined by the amount of goods and services that a unit currency can buy in the country, that is, by its purchasing power, so the exchange rate between the currencies of the two countries Can be expressed as the ratio of the purchasing power of the currencies of the two countries.

Absolute purchasing power parity

The magnitude of purchasing power is reflected in the price level. According to this relationship, the rise in domestic prices will mean the depreciation of the domestic currency relative to the foreign currency. Relative purchasing power parity makes up for some of the shortcomings of absolute purchasing power parity. Its main point can be simply expressed as: the exchange rate level of the currencies of the two countries will be adjusted accordingly according to the difference in inflation rates between the two countries. It shows that relative inflation between the two countries determines the equilibrium exchange rate between the two currencies. On the whole, the purchasing power parity theory reasonably explains the basis for determining the exchange rate. Although it ignores the influence of other factors such as international capital flows on the exchange rate, the theory is still valued by Western economists and has been used in basic analysis It is widely used in mathematical models for predicting exchange rate trends.

Absolute purchasing power parity refers to the ratio of the equilibrium exchange rate between domestic and foreign currencies equal to the purchasing power or price levels of domestic and foreign currencies.

Formula expression: Ra = Pa / Pb or Pa = Pb × Ra

Ra: the exchange rate for foreign currencies to domestic currencies

Pa: domestic price index

Pb: stands for foreign price index

It explains the decision of the exchange rate at a certain point in time. The main factor of the decision is the purchasing power of the currency or the price level.

Absolute purchasing power parity, if

If absolute purchasing power parity is established, relative purchasing power parity must be established, because the price index is the ratio of the absolute levels of prices at two points in time. Conversely, if relative purchasing power parity is established, absolute purchasing power parity is not necessarily established, for example, the exchange rate in the base period and the reporting period Both are equal to one-half of absolute purchasing power parity. At this time, relative purchasing power parity is established, but absolute purchasing power parity is not established.

The earliest analysis of the purchasing power parity of China's economic strength was Professor Clavis of the United States. He estimated that China's purchasing power parity in 1975 was 1 US dollar equal to 0.46 yuan. The first Chinese scholar to systematically study this problem was Professor Ren Ruoen. He estimated that China's purchasing power parity in 1991 was 1 US dollar equal to 1.13 yuan. Yi Gang and Fan Min estimated that in 1995 China's purchasing power parity of 1 US dollar was equal to 4.2 yuan. It can be seen that the forecast of exchange rate of absolute purchasing power parity often deviates greatly from the actual exchange rate.

Although various calculation results are inconsistent, one thing in common is that according to the theory of purchasing power parity, the RMB is undervalued, so the exchange rate should appreciate. This is also one of the theoretical bases held by scholars at home and abroad who advocate RMB appreciation. However, whether the RMB is undervalued so much, and whether we should make such a large adjustment to the exchange rate in full accordance with the PPP value obtained, is a question worthy of further analysis.

1 For any tradable commodity, the law of one price holds.

2 In the compilation of the price indices of the two countries, various tradable commodities have equal weights.

P = eP *

The meaning of the above formula is: the price levels of tradable goods in different countries are equal when measured in the same currency. The above formula is deformed, that is, e = p / p *

This is the general form of absolute purchasing power parity, which means that the exchange rate depends on the ratio of the price levels of tradable goods measured in different currencies, that is, the ratio of the purchasing power of tradable goods in different currencies.

The theory of absolute purchasing power parity explains the exchange rate decision. It is believed that the equilibrium exchange rate is determined by the purchasing power of the currencies of the two countries. The purchasing power is generally expressed by the general price level. Assume that P represents the domestic price level and P * represents the foreign price level. The equilibrium exchange rate E = P / P * is essentially the application of the law of one price, that is, the prices of the same commodity in different countries in different currencies are equal after conversion by the equilibrium exchange rate.