The purchasing power parity (PPP) model

The purchasing power parity (PPP) model is based on the idea that currency rates between two countries should be determined according to the relative prices of a basket of similar goods between these two countries. Any change in a country's inflation index must be offset by an opposite change in its currency exchange rate. Therefore, according to this model, when prices in a country increase due to inflation, its currency must depreciate to regain parity.

A basket of goods according to purchasing power parity

The basket of goods and services for the implementation of the PPP is made up of a sample of all goods and services included in the gross domestic product. This includes consumer goods and services as well as equipment, government services and construction projects. In the case of consumer goods, this includes food, drink, tobacco, shoes, clothing, rentals, water, electricity, gas, furniture, appliances household goods, fuel, personal transportation products, transportation services, medical goods and services, phones, educational, recreational and cultural services and equipment, repairs and maintenance.

The Big Mac index

One of the best known forms of the PPP model is the Big Mag Index created by The Economist magazine. Basically, the Big Mag Index is the exchange rate that would make a hamburger the same cost in the United States as in other countries. Comparing this value with actual prices indicates whether a currency is overvalued or undervalued. For example, in 2002, the exchange rate between the US dollar and the Canadian dollar was 1.57. A Big Mag hamburger in the United States cost $2.49 (USD) compared with $3.33 (CAD) in Canada, the equivalent of $2.12 (USD). Therefore, according to the PPP model, the USD/CAD currency pair was overvalued by 15% and should have been worth only 1.34.

The OECD's purchasing power parity index

As for the OECD (Organization for Economic Co-operation and Development), it has a more formal index. Within the framework of a joint program, the OECD and Eurostat share responsibility for the calculation of PPPs. Currently, data on currencies that are overvalued or undervalued against the US dollar can be found on the OECD's website (www.ocde.org).

Here, the OECD creates tables showing the price levels for the main developed countries. Each column indicates the number of specified currency units required in each of the countries specified in the list to purchase the same representative sample or basket of consumer goods and services. In this model, the representative basket costs 100 units in each country whose currency is specified. On this basis, a chart is created to compare the PPP of a currency with the real exchange rate. The chart is updated weekly to reflect the most recent price of the currency. It is also modified approximately three times a year to take into account the new PPP calculations. All PPP estimates are taken from OECD studies, although they cannot be considered as definitive because different calculation methods may produce different results.

Following the example of CAD/USD, OECD information indicates that during the month of December, the price of this currency pair on the market was 1.58, while the price level in the United States during this period compared to Canada was 122, which translates to a price of 1.22 for CAD/USD. Using this PPP model, analysts can determine that this currency pair was significantly overvalued by over 25%.

Limits of the purchasing power parity model

First of all, the PPP model should only be used as a fundamental long-term analytical tool. The underlying forces that influence the economies of countries eventually balance the purchasing power of currencies. However, it can take several years for this to happen, usually between 5-10 years.

One of the main weaknesses of purchasing power parity is that it assumes that goods can be traded easily, despite elements such as taxes and customs duties, for example. When a country imposes new tariffs on imported goods, there is an increase in the production costs of goods produced in the country, but these increases are not reflected in the PPP tables of that country.

Other factors must also be taken into account in determining the PPP, such as inflation, economic data and news, trade flows, interest rate spreads, asset markets and political events. Therefore, PPP is just one of many models that traders should study to try to predict market behaviour.