Purchasing Power Parity (PPP) - YouTube

In this video we will discuss purchasing power parity sometimes shortened to PPP

and relative purchasing power parity. Unlike the discussion in one of the

previous videos on interest rate parity (IRP) purchasing power parity is generally not

true. The reason interest rate parity works is

in many countries there is a free flow of currency between countries. People in

different countries can buy debt instruments in other countries and there

are active futures markets such as the Chicago Mercantile Exchange on currency

between countries. This makes IRP true for PPP to be true you would have to

have the free low flow of labor across borders, which we largely don't have and

a free flow of goods and other services across borders which regardless of the

discussion of free trade the world largely does not have. To give an example

under PPP the spot exchange rate between the Turkish lira and the dollar should

be the price of a product in the United States divided by the price of an

identical product in Turkey. In this example I get something that varies

drastically in price between these two countries. A product those of I us who

suffer from sinus infections use called Nasonex. The price of Nasonex in the

United States is around $350 and it available only by prescription. The price

of the same product (Nasonex) in Turkey is $5.00 and it is available

over-the-counter. Nasonex is also available in Europe for five to ten

dollars by prescription or in the United Arab Emirates for around twenty

dollars over the counter. If PPP was true 350 divided by five would get an

exchange rate of 70 Turkish lira per dollar. In reality the exchange rate is a

lot lower - 3.84. So PPP gives a drastically incorrect

result. Under a free market what would happen, is people would go to Turkey, they

would buy Nasonex for five dollars and they would sell in the United States for

three hundred and fifty dollars. They would keep doing this at a hefty profit

until the price went up in Turkey and down in the United States. Under our

current system both UPS and FedEx have been prosecuted for allowing people to

import these products from other countries and if you tried to do this

yourself you would probably be arrested for practicing medicine without a

license. The lack of the ability of these goods to flow across borders makes

PPP not true the same thing applies to things like labor. Labor gets paid a lot

more in the United States than Mexico, and a lot more in countries like Norway

than the United States, but it is illegal in many cases for Mexicans to come to

the U.S. to work or for Americans to go to Norway to work. These rules again

prevent PPP from being true. Relative purchasing power parity is very similar

in appearance to the equation for interest rate parity. Again we have a

future dollar, in this case Turkish lira, exchange rate equal to a spot dollar

Turkish lira exchange rate times now, rather than one plus the interest rate to

the number of years, we have one plus the inflation rate in dollars to the number

of years divided by one plus the expected inflation rate in Turkish lira

to the number of years. For an example we look at the current spot Turkish lira

dollar exchange rate. Since our equation up here has dollars per Turkish lira and

the quote we have off the internet is Turkish lira for dollars, the first thing

we have to do is invert this number. We merely invert 3.84 and we get the

current spot dollar Turkish lira exchange rate is

0.26. now we use our equation to try and predict from relative PPP what

the future dollar Turkish lira exchange rate will be. We take our 0.26 sticking

it here as D20 and then we look at the estimates of inflation in the United

States over the next two years of 3% and in Turkey of 10%. We have 1.03

squared divided by 1.1 squared. This gives a predicted future

dollar Turkish lira exchange rate in two years of around 0.23. Note this means in

two years it takes fewer dollars to buy a Turkish lira than it does today. This

is because the inflation rate is higher in Turkey than in the United States

which may indicate the Turkish central bank is printing more currency than the

US central bank. These equations don't tend to be

very accurate in predicting future dollar Turkish lira exchange rates. Over

the very long run PPP tends to start drifting to be true. This is because even

though you have barriers to labor crossing borders, cheap labor from Mexico

will come to the United States, and even though you have barriers to buying

Nasonex in Europe and selling it into the United States

some people will still do that. Others will go from the United States to Mexico

for healthcare. From the United States to Canada or to Europe for health care. Also

factories in high labor countries tend to relocate to low labor countries so

over the long run PPP does tend to have some predictive power in which way prices are

going to go. Thank you for watching this video.