Chapter 16: Problem 18

What is the purchasing power parity exchange rate?

Short Answer

Expert verified

The purchasing power parity (PPP) exchange rate is calculated by comparing the price of a fixed basket of goods in two countries and expressing the ratio of these prices as an exchange rate. To find the PPP exchange rate: (1) Collect the prices of the same basket of goods in both countries, (2) Calculate the price ratio by dividing the foreign basket price by the domestic basket price, (3) Obtain the market exchange rate, and (4) Divide the market exchange rate by the price ratio. The PPP exchange rate helps compare the relative value of currencies, considering the differences in the cost of goods and services.

Step by step solution

Understand Purchasing Power Parity (PPP) Exchange Rate

To calculate the PPP exchange rate between two countries, you need to compare the price of a fixed basket of goods in both countries. The basket should contain the same items in both countries to ensure comparability. This will give you the ratio of the price levels in both countries, which will be expressed as an exchange rate.

Collect the required data

To compute the PPP exchange rate, you need to collect data on the prices of the same basket of goods in both countries. The sources for this data might include official statistics agencies, international organizations, or data obtained from market surveys. Ensure that you have a reliable data source that represents the prices in both countries accurately.

Calculate the price ratio

Compute the price ratio by dividing the price of the basket of goods in the foreign country by the price of the basket of goods in your home country. This ratio represents the relative price level between the two countries.

Find the market exchange rate

Obtain the market exchange rate between the two currencies. The market exchange rate is the rate at which the currencies are exchanged in the foreign exchange market, and it is usually quoted in terms of how many units of the foreign currency can be exchanged for one unit of the domestic currency.

Calculate the PPP exchange rate

Divide the market exchange rate by the price ratio obtained in Step 3 to get the PPP exchange rate. The PPP exchange rate represents the amount of domestic currency needed to purchase the same basket of goods in the foreign country, taking into account the differences in the cost of goods and services.

Interpret the results

If the PPP exchange rate is higher than the market exchange rate, it means that the domestic currency is overvalued compared to the foreign currency. Conversely, if the PPP exchange rate is lower than the market exchange rate, the domestic currency is undervalued relative to the foreign currency. This information can be used by policymakers, economists, and investors to understand the dynamics of international trade and the value of currencies.

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