what is the ppp theory of exchange rate?

Answer 1

Suppose a Big Mc costs $3.75 in US and $2 in UK then purchasing power parity says 1 US$ is equivalent to $2/3.75UK$. Now convert the GDP of UK into US dollars at the published exchagne rate from Pound and DIVIDE that by the equivalent UK$ value got above and you will get PPP based GDP of UK. Mc Burger is assumed to be homogenous in UK and USA. If you want to be more puritanical you can choose a whole basket of goods and services that are similar in one country and USA and do the same method of calculation. For just knowing what it is even McBurger analogy is good enough and accurate enough.
Theory is even more elaborate. Usually this theory of calculating PPP based GNP or GDP was formulated by International Bank for Reconstruction based in Switzerland. The problem with their theory is they multiply instead of DIVIDE what I have shown above by way of which if you apply it gives erroneous results like a poor country suddenly generates GNP higher than some of the rich countries when PPP based GNP is compared and some of these countries uses it to be all the more slack in their adminstration of the country. If you DIVIDE the problem will be sloved and accurate GDP of GNP will be got where poor countries cannot manipulate their numbers. It is absurd you see to think that poor countries have matching national income numbers when meassured using PPP and lower otherwise. It takes real work to generate high national income and just changing the way you meassure cannot change the underlying facts so drastically.
For theory one should work from, consumer price index, purchasing power of currency and something called 'unitary confinement theory' whic I developed which assumes that for prices below 1 unit currency for any comparable product in different countries can be a good yardstick for the purchasing power embedded in local currencies. In these numbers the prices behave close to each other and higher numbers are only magnification of these smaller numbers. It is also easier to compare products or services of smaller value like a pay phone charge, a can of coke etc;.


Former

Answer 2

What Trolling says is close but not quite right. PPP theory does not say that things should cost the same in different countries once you account for currency exchange. There is a related idea, the "law of one price", that says IN AN EFFICIENT MARKET a good has only one price -- any price difference would be arbitraged away pretty quick.

However, everyone clearly understands that International trade does not at all allow for such an efficient market among different countries. Even from the US to Canada, there is not sufficient physical transfer of goods and there is too much government interference to arbitrage away the price difference.

Instead PPP is a tool used to help clarify the prevailing REAL price differences.The "PPP Exchange rate" is a rate based on PPP rather than what the currency exchanges are actually doing.

It might be used this way: Based on the nominal currency exchange rate, someone in Country A makes $50,000 US Dollars a year. But on a PPP basis -- considering how much stuff they can actually buy in their country with that income, as opposed to what $50k would buy in the US -- their income is only equivalent to $25K US Dollars, because things are more expensive in their country.

Answer 3

That exchange rates exactly reflect differences in purchasing power between the countries.

For example, assume that one US dollar = two Canadian dollars.

According to PPP theory, then, if a car costs $10,000 USD, if you go to Canada it should be priced at $20,000 CAD.

This does not hold exactly true in real life for a variety of reasons: the mobility of capital and labor, transportation costs, etc, etc.; but The Economist does a "Big Mac" index every week where they test this theory using the price of a Big Mac.......it actually reflects the PPP in trends.

Answer 4

Forward Rate = Spot Rate X ( 1 + Foreign Inflation Rate) / (1 + Home Inflation Rate)

Answer 5

Markets are not continually in equilibrium interior the jiffy period so parity will in many circumstances not be executed. A devalued overseas money helps overseas change to have more beneficial buying power because their cost continues to be the same at the same time as the cost of things decreases interior the devaluing u . s ..