What Is the Connection Between Purchasing Power Parity and Exchange Rates?

Purchasing power parity theory is a theory that studies and compares the purchasing power relationship between different currencies in various countries. Swedish scholars have studied the issue of purchasing power parity earlier. Sweden had a floating exchange rate in 1745-1777, leaving the parity parity, and the exchange rate fluctuated sharply thereafter. The government's attempts to intervene to stabilize the exchange rate have repeatedly failed. In addition, because of Sweden's participation in the British-French war for seven years, domestic inflation has increased.

Purchasing power parity theory

1. Do not consider transaction costs in international trade.

Purchasing power parity theory is about

The demand for foreign currency is because it can be used to purchase foreign goods and services, and foreigners need their national currency because they can use it to buy domestic goods and services. Therefore, the exchange of domestic currencies with foreign currencies is equivalent to the exchange of purchasing power between domestic and foreign currencies. So the price of a foreign currency in its own currency is

The reason why domestic people need foreign currency or why foreigners need national currency is because these two currencies have purchasing power for commodities in each issuing country;

This theory was born just after the end of the First World War, and was the product of turbulence in the world economy. At that time, countries successively changed from the gold standard to the currency circulation system.

Against the background of today's global economic development, the competition of the comprehensive national strength of various countries is largely a competition of economic strength.

Comparing the economic strength of the two countries, gross domestic product (GDP) is the most intuitive indicator. To compare the GDP of different countries, you must first convert the GDP calculated in the national currency units of the countries into the prevailing U.S. dollars. There are many different ways to convert. After development, the so-called "purchasing power parity method" has attracted people's attention. Because calculated by this method, China's economic scale will exceed that of the US boss within five years.

Purchasing Power Parity Economist Perspective

The method of calculating GDP using the current exchange rate is very simple. According to the exchange rate at that time, the total GDP calculated can be directly converted into US dollars. The calculation of "purchasing power parity" is much more complicated.

Purchasing power parity (PPP for short) is an economically equivalent coefficient between currencies calculated according to the different price levels of countries in order to make a reasonable comparison of the GDP of each country.

The purchasing power parity exchange rate makes it easier to compare living standards between different countries. For example, if the renminbi depreciates by half against the US dollar, then the GDP in US dollars will also be halved. However, this does not mean that the Chinese have become poor. If the income and price levels in RMB remain the same, and the imported goods are not important to the living standards of the people (because the price of imported goods will double), then the devaluation of the currency will not bring people's lives Significant deterioration in quality.

Some economists have pointed out that there are more than 30 methods for calculating the exchange rate of a country, and the purchasing power parity method is only one of them. This method has some truth, but most countries and most economists in the world will not use this method.

Purchasing Power Parity Big Mac Index

How much is a hamburger?

A simple and interesting example of measuring purchasing power parity is the Big Mac Index.

This indicator was pioneered by the British "The Economist" magazine and has become a popular standard. The Economist assumes that the cost of McDonald's Big Macs sold worldwide is fixed, and then compares the prices it sells in stores across countries.

According to the latest issue of the magazine's Big Mac Index, the price of a Big Mac hamburger is 13.2 yuan in China and 3.77 US dollars in the United States. From this, it can be inferred that the exchange rate of the RMB to the US dollar should be 3.54: 1, which is lower than the exchange rate. A lot lower. In fact, the exchange rate of the RMB to the US dollar calculated according to the "Big Mac Index" has always been much lower than the current exchange rate. Therefore, this index is often used by some western economists to support various theories of "the yuan is undervalued."

Professor Feng Pengcheng, director of the International Investment Research Office of the Institute of International Economics at the University of International Business and Economics, believes that judging from the perspective of whether a country s exchange rate is undervalued is not accurate.

"The United States is a country dominated by the service industry, but China is not." Feng Pengcheng said, "In addition, the United States' raw materials, labor costs, and people's income levels are higher than China's. Using the statistical Big Mac index method to assess the exchange rate Without taking these other factors into consideration. "

PPP theory has obvious flaws

The main disadvantage of PPP theory is that it assumes that goods can be traded freely and does not take into account transaction costs such as tariffs, quotas and taxes. Another disadvantage is that it only applies to goods, but ignores services, and services can just have a very significant value gap. In addition, in addition to the difference in inflation and interest rates , there are several other factors that affect the exchange rate , such as economic digital releases / reports, asset markets, and political developments.

It's easy to make a mistake

There are obvious flaws in the theory of purchasing power parity. First, purchasing power parity ignores the impact of international capital flows on exchange rates. Although the theory of purchasing power parity has its irreplaceable advantages in revealing the root causes and trends of long-term changes in exchange rates, in the short to medium term, the impact of international capital flows on exchange rates is increasing.

The People's Bank of China has repeatedly warned of the impact of international hot money inflows on the RMB exchange rate. In 1998, as the trigger of the Asian financial crisis, the sudden fluctuations in the exchange rate of the Thai baht against the US dollar were the result of the hype of international hot money.

There are even more critics who simply point out that the premise of purchasing power parity, that is, "assuming that the prices of goods in all countries are equal" is itself wrong. Because people in different countries value the same product differently. For example, a commodity that is a luxury product in country A may be just a general commodity in another country. And purchasing power parity doesn't matter.

Moreover, the calculation of purchasing power parity requires the selection of a large number of products as the basis for calculation, and the selection process will inevitably be partial. The International Monetary Fund's PPP calculation of the GDP of each country is based on the International Comparison Project (ICP), which claims to cover 155 basic consumption categories and is the largest statistical activity in the world.

Therefore, economists believe that PPP is statistically deceptive, and it is possible to obtain favorable or unfavorable results for a country by carefully selecting the goods used.