Purchase power parity pdf

Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies. Their study results in the famed "Big Mac Index". Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.

Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.

Government sales taxes such as the value-added tax VAT can spike prices in one country, relative to another. Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper. The Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.

Goods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.

While it's not a perfect measurement metric, purchase power parity does allow for the possibility of comparing pricing between countries that have differing currencies. World Bank. That formed the basis for today's PPP. PPP depends on the law of one price. In theory, once the difference in exchange rates is accounted for, then everything would cost the same. This isn't the case in the real world for four reasons. First, there are differences in transportation costs, taxes, and tariffs.

These costs will raise prices in a country. Countries with many trade agreements will have lower prices because they have fewer tariffs. Socialist countries will have higher costs because they have more taxes. A second reason is that some things, like real estate and haircuts, can't be shipped.

Only ultra-wealthy global travelers can compare the prices of homes in New York to those in London. A third reason is that not everyone has the same access to international trade. For example, someone in rural China can't compare the prices of oxen sold throughout the world. But Amazon and other online retailers are providing more real purchasing power parity to even rural dwellers.

A fourth reason is that import costs are subject to exchange rate fluctuations. For example, when the U. The most significant driver of changing exchange rate values is the foreign exchange market. It creates wide swings in exchange rate values. When traders decide to short a country's currency, they effectively reduce costs throughout that country.

International Monetary Fund. The World Bank. Central Intelligence Agency. The Library of Economics and Liberty. Even if the currency fluctuates in the short term, purchasing parity hopefully remains over the long term. See Figure 2 in the Appendix on Page 8. Unfortunately, if an economist calculates GDP with the standard domestic currency rates, it can lead to an inaccurate picture.

Experts often point to the example of China, which intentionally devalues its currency. By adjusting for the assumed purchasing parity that China has with the United States, economists can provide a more accurate idea of the nation's wealth. A common proposal is to erect trade barriers which may further distort markets. Readjusting the currency to match actual purchasing power can solve the problem without excessive government involvement.

According to Rose , it shows that trade and payment between countries change mainly due to changes in relative price levels of the countries concerned In the long run; therefore, the exchange rates depend on relative prices and price changes. The theory has its importance when price movements are a significant factor affecting exchange rates. But when price fluctuations are not so important, the theory has little significance.

Another advantage of PPP is that when combined with money, demand and supply, PPP leads to a very useful theory of how exchange rates and monetary factors interact in the long run.

This theory is called monetary approach to the exchange rate. This approach generally predicts that the exchange rate is fully determined in the long run by the relative supplies of those monies and the relative real demands for them. Other notable and useful predictions of this approach are shown in figure 4 of the appendix on page 9 2. However, in reality there is no such direct and precise link between the two.

There are many factors apart from the purchasing power of currencies, such as tariff, speculation, capital flows, cost of living and wholesale price index numbers etc. Moreover, Krugman argues that price indices in different countries are not comparable, as they are constructed on different bases and differ in respect of the base period, representative commodities included weights assigned to different items and the method of averaging.

Also, since inflation data in different countries is based on different commodity baskets, it is not possible for exchange rates to cancel out inflation variations even if barriers of trade are non-existence and products are tradable.

The Keynes theory, therefore, remarks that" confined to internationally traded commodities, the purchasing power parity theory becomes an empty truism. This assumption is not tenable, when the very base of international trade is geographical specialization in production. Moreover, the concept of a change in the price is vague in theory. Prices of all commodities never move uniformly.

Most of the existent work on persistence of PPP deviations using long-horizon data, including Abuaf and Jorion , Glen , Lothian and Taylor , and Murray and Papell , uses real exchange rates computed from nominal exchange rates and wholesale price indexes. Taylor computes real exchange rates using consumer price indexes.

Since the consumer price index contains a larger component of non-traded goods than the wholesale price index, it is not surprising that the persistence of PPP deviations is larger. Given that half-life confidence intervals based on the DF-GLS regression are shown in Table 2 to be uniformly narrower than those based on the ADF regression, it may seem puzzling that the confidence intervals in Table 3 are not all tighter than those in Table 4. Both sets of confidence intervals, however, are narrower than what currently exists in the literature, and the message from Tables 3 and 4 is the same.

Using the largest available dataset, we are unable to reconcile the predictions of exchange rate models with nominal rigidities with the behavior of real exchange rates. Therefore, while tighter confidence intervals translate to more information about the persistence of deviations from PPP, this increase in information moves us away from solving the PPP puzzle.

Subsequent work using data for industrialized countries from the post flexible exchange rate period has obtained ambiguous conclusions. In Murray and Papell and Rossi , the confidence intervals for half-lives are so wide that they are consistent with virtually anything. They range from a speed of reversion to PPP that is predicted by models with nominal rigidities half-lives between 1 and 2 years to the failure of PPP to hold in the long run infinite half-lives.

Murray and Papell also examine long-horizon data for six countries, and report similar results. We extend the median-unbiased estimation methodology developed by Andrews and Andrews and Chen to the efficient DF-GLS test of Elliott, Rothenberg, and Stock , and report both point estimates and confidence intervals. Another contribution of our work is to augment the information conveyed by point estimates with confidence intervals.

In our earlier work using long-horizon data, as well as in work using post data, median-unbiased confidence intervals for PPP deviations were too wide to be informative. In this paper we see something much different.

Similar to previous work, the upper bounds of the confidence intervals are so high that we cannot rule out the failure of PPP to hold in the long run. In contrast to previous work, however, the lower bounds are also so high that we can rule out consistency with models based on nominal rigidities. While our quantitative results are very different from those reported by Rogoff, our conclusions are in some respects very similar.

Using more powerful and more complete techniques with better data moves us further away from solving the PPP puzzle. Andrews, D. Cheung, Y. Choi, C. Diebold, F.

Elliott G, and Stock, J. Elliott, G. Engel, C. Frankel, J. Hafer, ed. Glen, J. Hansen, B. Inoue, A, and L. Kilian, L. Lothian, J.