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by on 4 November 2013

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Outline (PPP)
Definition
Functions
Pros
Cons
Calculations
Conclusion
Definition/ Concept
Functions
PPP exchange rates can be useful for making comparisons between countries.

Exchange rates move in relation to PPP in the long term.

PPP rates facilitate international comparisons of income, as market exchange rates are often volatile.

What are the main advantages of PPP?
PPP exchange rates are relatively stable over time and not as volatile as market rates.

Unlike market-based rates, PPP takes into consideration both traded and non-trade goods.

 PPP is harder to measure than market-based rates.

PPP rates must b estimated, which can lead to inaccuracies.
Purchasing Power Parity (PPP) is the ratio between the currencies of two countries at which each currency when exchanged for the other will purchase the same quantity of goods as in home country.

It compares the price of trade between two countries using a basket of goods and services.

Comparing the prices of a basket of items theoretically it can determine if prices and therefore currency strength is too high or too low in a country.

It is necessary to compare the cost of baskets of goods and services using a price index.

PPP calculation (Coke and Pepsi)
Pound Sterling/USD spot rate : 0.6212

US Dollar/ Pound Sterling Indirect Rate : 1.60977

Price of Coca - Cola in the United States (usd): \$0.72

Price of Coca- Cola in England (pound): \$0.75

Price of Pepsi in the United - States (usd) : \$0.85

Price of Pepsi in England (pound): \$0.25
Cont'd
Formula: Spot exchange rate = Ph /Pf

Ph = Price in the home country

Pf = Price in the foreign country

Coca Cola calculation
1.59 = 0.72/0.75

Pepsi Calculation
1.59 = 0.85/0.25

Calculation Analysis
There is no equality of price between the products sold in the United States and the same item sold in the United Kingdom.

Coca-Cola
1.59 * 0.75 (direct rate multiplied by the price of Coke in England)
= \$1.20 USD

Analysis Cont'd
Pepsi

1.59 * 0.25 (direct rate multiplied by the price of Coke in England)
= \$0.40 USD

Analysis Cont'd
For there to be equality, the Price of Coke and Pepsi in England should be:

Coca- Cola
0.63 * 0.72 (indirect rate multiplied by the price of Coke in the U.S)
= 0.45 Pounds

Pepsi
0.63 * 0.85 (indirect rate multiplied by the price of Pepsi in the U.S)
=0.53 Pounds
Conclusion
An individual can spend differing amounts of currency for the same product in two different locations indicates an opportunity for Arbitrage profits to be made.

In theory, Purchasing Power Parity should result in 'one price' for each good.

In practice when one considers the many other extraneous factors involved, we cannot expect that Purchasing Power Parity would hold.
BIG MAC Index
1.59 = 0.96

Purchasing Power Parity does not hold.
1.59 = 3.40
Purchasing Power Parity does not hold
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