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OzWatch Economics: Purchasing Power Parity
02 May 2001 The other day, if you have been watching television on channel 7, the spin is there. David Koch was talking up the dollar. Using the Mac Index, ala purchase parity power (PPP), he points out that the Australian dollar was undervalued by as much as 40%. What he forgets to tell you that the Chinese RMB and the Indonesian rupiah were also undervalued. Using the same calculations, they were respectively about 60% and over 70% undervalued. How inane and stupid can you get? It is no wonder this country is on the skids when you have economic commentators offering such analyses.
The Problem with Statistics
Ok, so what’s this PPP, you ask? It is a tool used by economists and businesses who argued that they are better indicators than the standard Gross National product indicators. They measure relativities and differences across countries giving us better and more realistic assessment of competitiveness of a country. And what better than the ubiquitous global Big Mac.
Our economists and businesses argue, that the problem with international cost comparisons is the conversion of different currencies from the countries involved into a base currency, which is necessary if a cost comparison is to be done. Four major problems can be discerned: When costs in one country are identified they do not provide indicators of quality, durability or other performance measures. For example there are office buildings completed in Shanghai in 1997 at a low cost relative to Australia that have facades detaching from the frame and are cracking across the floors after 18 months. Straight cost/m2 comparisons are particularly poor in this regard. If the cost in local currencies is analysed to find the all-up cost the advantages of cheap labour and materials are typically lost through poor productivity, ie. labour at half Australian or US rates may only be half as productive.
There are differences in relative prices between countries, and these differences can be due to a range of factors such as resource endowments or availability of capital. Finally, exchange rates are volatile and currencies are prone to "overshooting" (going above or below their expected ranges). Conversion of domestic prices at current exchange rates (or even 12 month average exchange rates) often reflect the state of the foreign exchange market rather than domestic prices and values. There are no easy or simple ways to adjust for the quality and productivity problems. Likewise, differences in relative prices and foreign exchange market fluctuations affect international comparisons of costs.
Enter the PPP
Purchasing power parities (PPPs) are the rates of currency conversion that eliminate the differences in price levels between countries. Per capita volume indices based on PPP converted data reflect only differences in the volume of goods and services produced. Comparative price levels are defined as the ratios of PPPs to exchange rates. They provide measures of the differences in price levels between countries. The PPPs are given in national currency units per US dollar. Since 1967 a UN sponsored research project has been running - the International Comparison Program (ICP) - to develop and refine PPP measures. The 1985 ICP created a global framework that was extended by the World Bank in 1995 to 130 countries. There have been a number of tables published that rank these countries by quality of life, GDP per capita, by development indicators and so on. In some cases the ranking of individual countries can change markedly according to the criteria used.
PPP is the accepted method used by the UN, World Bank and other international organisations for inter-country cost comparisons. PPP typically attempts to establish living standards using the real value of local costs, by incorporating local prices and calculating the purchasing power of local incomes. This purchasing power is then converted into a common currency, usually US dollars, and a comparison made. Despite the theory of PPP, it is more common to find purchasing power disparity in global currency markets. ICP collects data on prices paid for a large set of comparable items in many countries. A country's international price level is the ratio of its PPP rate to its official exchange rate for US dollars.
PPPs can, therefore, be thought of as the exchange rate of dollars for goods in the local economy, while the US dollar exchange rate measures the relative cost of domestic currency in dollars. Thus the international price level is an index measuring the cost of goods in one country at the current rate of exchange relative to a numeraire country, in this case the United States. An international price level above 100 means that the general price level in the country is higher than that in the United States. For example, Japan's international price level of 137 in 1997 implies that the price of goods and services in Japan is 37 percent higher than the price of comparable goods and services in the United States. By contrast, Kenya's price level of 30 means that a bundle of goods and services purchased for $100 in the United States costs only $30 in Kenya. A figure above 100 indicates that the price of that component is higher than the average price level of GDP. This is not the same as saying that the component is more expensive in that country than in the United States. It indicates only that the price for that component is higher than the general price level prevailing in that country.
There have been ongoing efforts to make international comparisons of living costs and standards. In order to overcome the cost comparison problem PPP has been used. This has a theoretical base in the `law of one price' (the same commodity should cost the same in different countries) and an extensive empirical literature. PPP attempts to value domestic production (GDP) by using international prices.
The main areas for which PPPs are important, besides international comparisons of living costs, are determination of interest rate differentials and exchange rate management. In both of these areas the key factor is relative rates of inflation between countries, and expectations of movements in interest rate differentials and long-run exchange rates based on inflation.
Problems with Tools
The measurement of income levels at PPPs raises conceptual and practical problems which are not fully dealt with by the explanations that international prices have been used to value domestic production, or that the estimates are not always directly comparable. Even if all of these difficulties could be overcome, there would be marked shifts in the rankings of countries depending of which concept of income or output was used. The effect on building costs of international cost comparisons and purchasing power parity has highlighted the general issues involved. When applied to a specific industry and product these problems are compounded. The scope for egregious errors in the analysis and method of comparison is great, and many assumptions have to be made for the comparisons to be useful.
Established PPP indices are usually dated as they take several years to be published. For developed countries this may not be a significant problem, but with developing countries the effect of recent economic events may render the indices unreliable. Commodity Adjustment An alternative to using international exchange rates to determine comparative value, adopting the principle of purchasing power parity, is to express the local currency costs as a ratio to a standard commodity which is of constant quality and specification and sold in all countries. Exchange rate fluctuations are therefore removed from the equation. Such an approach also takes account of variations in living standards, and it is suggested that the outcome may be a better basis for cost comparison across different economic environments than PPP. Nevertheless, it is a particular form of purchasing power parity.
The Big Mac
The Economist has explained that its "Big Mac" index was devised as a rough guide to determine whether currencies are at a correct PPP level. The worldwide survey of the price of a standard hamburger at McDonald's is at the opposite extreme to the ICP. Instead of pricing hundreds of commodities, services and labour inputs in a country and then weighting the resulting price relativities by expenditure, the price of a single commodity is taken as representative of all final prices. The index does capture many significant intermediate prices in the final price, including those of several foodstuffs, packaging, various categories of labour services, fuel and power, commercial rents and so on.
There is a limited choice for such a benchmark commodity. The Economist magazine publish an index regularly which compares countries on the basis of a McDonalds Big Mac hamburger. Known as the "Big Mac Index", it offers a guide to whether currencies are at their correct level. It is based on purchasing power parity - the notion that an identical basket of goods and services should cost the same in all countries. It therefore shows the under or over valuation of currencies by translating the normal price of a Big Mac hamburger into US dollars. Countries where the adjusted price is greater than the US have an overvalued currency, and vice versa.
In other words, when someone next talks of PPP or the Big Mac, you know they are actually taking of pay cuts or have another agenda. PPPs and its like are actually tools used to legitimise widening income inequalities and gap between nations. Sadly, it also reinforces western consumption behaviour but more to the point, they cannot ever factor in all the variables – it’s just make believe. So, when you meet and/or read/hear these pearls of wisdom think again and if you can respond, tell them to eat crow. Better still, tell them to take a pay cut, especially if they are expatriates in developing countries. ...Link