3.1. Exchange rate at purchasing power parity
(Purchasing Power Parity Rate - PPP Rate)
The course of purchasing power parity is the ideal exchange rate, calculated as a weighted average price ratio for a standard basket of industrial, consumer goods and services between the two countries. In the ideal model of the formation rate, based only on prices of the two countries trade with each other, the real exchange rate would be equal to the rate of purchasing power parity.
This method of determining the exchange rate is peculiar to the system of fixed exchange rates (the gold standard, Bretton Woods system).
According to experts in June 1994. dollar exchange rate to the deutsche mark, the purchasing power parity, was:
on consumer prices (consumer prices) 1.68
Industrial prices (producer prices) 1.82
Cost of services (services prices) 2.05
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On average, 1.82
In fact, the dollar-mark in June 1994 stood at 1.65, ie much lower than the PPP.
In the long run (several years), the real exchange rate tends to fluctuate around the value of purchasing power parity, parity but he is constantly recalculated as changes in price levels in the countries being compared.
One of the fundamental concepts underlying the theory of PPP - the rule of one price: the same goods are purchased directly by the foreign currency or after conversion. In other words, for every product we have the following expression:
Pi (t) = S (t) x P `i (t)
t - the index point in time; i - the index of the goods; S (t) - the current exchange rate; Pi (t) - the price of goods in national currency; P `i (t) - the price of goods in foreign currency.
In this formulation, the rules laid down one price hypothesis of zero distribution costs, the absence of trade barriers (both tariff and non-tariff) and the homogeneity of the products. The rule of one price is valid only if all items have equal weight in both countries. Hence seriously conclude that if the economic structures are different, then the PPP theory is wrong, even if the rule of one price holds.
In the relativistic version of the theory of PPP is taken not absolute price levels, and their indexes. Thus, measured not purchasing power parity, and their index:
P (t + T) / P (t) = [S (t + T) / S (t)] x [P `(t + T) / P` (t)]
This formulation of the theory of PPP rather than its absolute version. However, even she is not good because it gives crashes when the structure of production and relative prices of goods in different economies are changing. However, for short periods of time, the theory of PPP could provide quite a plausible explanation of trends in exchange rates.
PPP theory is also good because it allows to take into account the effect of inflation. Let f - rate of inflation in the economy, and f `- the inflation rate in the foreign economy. Then, by definition, inflation,
P (t + T) = 1 + f P (t) P `(t + T) = 1 + f` P `(t)
PPP calculations are widely practiced for the development of national economic policy. Central banks rely on PPP estimates in determining the parities of their currencies. This is of particular importance for the management of the real exchange rate (R):
P (t + T) / P (t) R (t + T) = [S (t + T) / S (t)] x [P `(t + T) / P` (t)]
If the observed R <1, the real purchasing power of the national currency against foreign goods falls, and increasing export competitiveness. Conversely, R> 1 - means that the domestic currency depreciates faster than the differential between domestic and foreign inflation.
