In this case, since the U. Is overvaluation or undervaluation good or bad? That depends on what a person is trying to achieve.
For example, if the U. In fact, the more overvalued the dollar is, the better. However, for an exporter of U. Thus an overvalued dollar will likely reduce sales and profits for these U. The second way over- and undervaluation is sometimes applied is in comparison to an exchange rate presumed necessary to induce trade balance, or balance on the current account.
If one imagines that a trade deficit, for example, arises primarily because a country imports too much or exports too little rather than being driven by financial decisions tending to cause a financial account surplus , then one may also look for ways to either reduce imports or raise exports.
A change in the exchange rate offers one viable method to affect trade flows. Suppose the United States has a trade deficit which it indeed has had for more than thirty years prior to At the same time, a dollar depreciation would also cause U. Sometimes economists make numerical estimations as to how much the dollar value would have to fall to bring trade into balance.
These estimations are enormously difficult to make for several reasons and should be interpreted and used with great caution, if at all. The exchange rate that balances trade would depend on the values taken by all the other factors that also influence the trade balance. Different values for all the other variables would mean a different exchange rate needed to balance trade. Instead, there is a different exchange rate value that will balance trade in each and every alternative circumstance.
Indeed, even the current exchange rate—whatever that is—can balance trade if other factors change appropriately. When it is believed a depreciation of the currency is needed to balance trade, they will say the currency is overvalued. When it is believed an appreciation of the currency is needed to balance trade, they will say the currency is undervalued.
Under this notion, a currency can never be over- or undervalued in a floating exchange rate system. In a fixed exchange rate system, a government can sometimes intervene to maintain an exchange rate that is very different from what would arise if allowed to float.
In these cases, large trade surpluses can arise because the government maintains an artificially low value for its currency. Calls for a revaluation appreciation of the currency, to promote a reduction in a trade surplus, are somewhat more appropriate in these cases since the market does not determine the exchange rate. Similarly, large deficits could be reduced with a devaluation depreciation of the currency.
Use the information about the hourly wage for a high school principal and exchange rates to answer the following questions:. Probably the most important application of purchasing power parity PPP exchange rates is in making cross-country comparisons of income, wages, or gross domestic product GDP.
With a population in the United States of million people, per capita U. Thus we need to convert units, either turn dollars into yuan or yuan into dollars. The simplest approach to make this conversion is to use the spot exchange rate that prevailed in , which was 8. However, there is a problem using this method. One thing that is quickly recognized by Americans when they travel in and around China is that many goods and services seem considerably cheaper than they are in the United States.
The implication is that although U. GDP per person is thirty times higher, that income may not purchase thirty times more goods and services in the U. A solution is found in the purchasing power parity theory PPP. When prices for similar goods differ as described in the previous paragraph, we would say the U. One way to reach comparable or equalized values of goods and services between the countries is to apply the PPP exchange rate in the conversion. The PPP exchange rate is that exchange rate that would equalize the value of comparable market baskets of goods and services between two countries.
For example, the estimated PPP exchange rate between the U. If this exchange rate had prevailed between the countries, the prices of U. Now, if we use this exchange rate to make the conversion to dollars of GDP per capita in China, then we will get a number that reflects the purchasing power of Chinese income in terms of the prices that prevail in the United States—that is, in terms of prices that are equalized between the countries.
The PPP method of conversion is a much more accurate way of making cross-country comparisons of values between countries. The higher value takes account of the differences in prices between the countries and thus better reflects the differences in purchasing power of per capita GDP.
For most comparisons concerning the size of economies or standards of living, using PPP is a more accurate method and can fundamentally change our perception of how countries compare. To see how, consider Table 6. It shows a ranking of the top ten countries in total GDP converting to dollars using both the current exchange rate method and the PPP method. Table 6. The United States remains at the top of the list using both methods.
However, several countries rise up in the rankings. China rises from the third largest economy using current exchange rates to the second largest using PPP. This means that in terms of the physical goods and services produced by the economies, China really does produce more than Japan. PPP conversion gives a better representation of the relative sizes of these countries. Similarly, India rises from twelfth rank to fourth. Russia also moves up into sixth place from ninth. Canada moves out of the top twelve, being replaced by Mexico, which rises up to eleventh.
So using the current exchange rate method underestimates the true size of their economies. For the other countries, their currencies are overvalued to the dollar, so converting their GDPs at current exchange rates gives an overestimate of the true size of their economies.
In February , the Mexican peso—U. The price of a hotel room in Mexico City was 1, pesos. Previous Chapter. Table of Contents. Next Chapter. Chapter 6 Purchasing Power Parity Purchasing power parity is both a theory about exchange rate determination and a tool to make more accurate comparisons of data between countries.
Identify the conditions under which purchasing power parity holds. The Law of One Price LoOP The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Price of videos in U. From LoOP to PPP The purchasing power parity theory is really just the law of one price applied in the aggregate but with a slight twist added.
Key Takeaways The law of one price says that identical goods should sell for identical prices in two different markets when converted at the current exchange rate and when there are no transportation costs and no differential taxes applied.
The purchasing power parity theory is an aggregated version of the law of one price. The purchasing power parity condition says that identical market baskets should sell for identical prices in two different markets when converted at the current exchange rate and when there are no transportation costs and no differential taxes applied.
Exercises Jeopardy Questions. The term used to describe a collection of goods and services consumed by a typical consumer. The term used to distinguish PPP based on price levels rather than inflation rates. The term used to describe the economic principle that identical goods should sell at identical prices in different markets. Exercise Suppose a consumer purchases the following products each week: ten gallons of gas, fifteen cans of beer, three gallons of milk, and two pounds of butter.
Calculate the cost of a weekly market basket in the initial base period. Calculate the cost of a market basket one year later. Construct the price index value for both years. What is the inflation rate between the two years? Key Takeaways An increase in Mexican prices relative to the change in U. More rapid inflation in the United States would cause the dollar to depreciate while the peso would appreciate. Exercise Jeopardy Questions.
Of increase , decrease , or no change , the effect on the supply of dollars in the foreign exchange market if a market basket costs more in the United States than it does in Germany.
Of increase , decrease , or no change , the effect on the U. Perfect information. The law of one price assumes that individuals have good, even perfect, information about the prices of goods in other markets.
Only with this knowledge will profit seekers begin to export goods to the high price market and import goods from the low-priced market. Consider a case in which there is imperfect information.
Perhaps some price deviations are known to traders but other deviations are not known, or maybe only a small group of traders know about a price discrepancy and that group is unable to achieve the scale of trade needed to equalize the prices for that product. In either case, traders without information about price differences will not respond to the profit opportunities and thus prices will not be equalized.
Thus the law of one price may not hold for some products, which would imply that PPP would not hold either. Other market participants. Notice that in the PPP equilibrium stories, it is the behavior of profit-seeking importers and exporters that forces the exchange rate to adjust to the PPP level. Thus it is reasonable to say that the PPP theory is based on current account transactions. This contrasts with the interest rate parity theory in which the behavior of investors seeking the highest rates of return on investments motivates adjustments in the exchange rate.
Thus the interest rate parity theory is based on capital account transactions. 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.
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