Question

must be 800 words - paragraph form and not word for word from google.

Explain the differences between Market Exchange Rates (FX) and Purchasing Power Parity (PPP). What are the advantages and disadvantages of using PPP measures for comparing incomes across countries?

Answer 1

Market exchange rates are the price of home currency in terms of foreign currency or vice versa. The market exchange rates are determined through the market forces of demand and supply of currencies. If the demand for home currency for reasons like higher domestic interest rate or higher demand for domestic goods due to lower prices, the domestic currency prices will appreciate and therefore, exchange rate will go up. However, Market exchange rates are not a good measure for comparing economies since, they do not reflect on the prices in different economies. If we need to compare two economies, it is imperative to compare in real terms. The real exchange rate is given by the purchasing power parity (PPP) which measures the unit of currency needed to buy same basket of good and service in two nation and then comparing them together. For example, if a sandwich costs $2 in US and £1 in UK, this would imply a PPP exchange rate of 1 pound to 2 U.S. dollars.

Whenever financial flows are involved, it is better to use market exchange rates like current account balance are compared using Market exchange rates to compare flow of financial resources. So which method is better? The appropriate way to aggregate economic data. However, for comparing real variables like Gross Domestic Product, GDP or its growth, it is always better to compare using PPP exchange rate to get a better and clearer idea about the standard of living in across countries.

The main advantage of PPP over market exchange rate is the stability of PPP exchange rates as the prices tend to be stable across nation compared to the market exchange rates that more volatile. Also, the market exchange rate can be used only in case of internationally traded goods i.e. exports and imports and do not reflect on domestic prices of non-traded goods that can be lower in developing nation than the developed nation or high-income countries.Services are cheaper in low-income countries like India, because of the lower wages and service sector being labor intensive in developing nations. An economic analysis using market exchange rate will fail to take into account the differences in the prices of nontraded goods across economies and will therefore, underestimate the purchasing power of consumers in developing economies consequently, their overall standard of living. For this reason, PPP is generally regarded as a better measure of overall welfare and hence, a better measure for economic analysis across nations. However, the calculation of PPP is a dauting task because of the complexities involved due to large number of goods and services produced in an economy. It requires huge statistical data handling and therefore, the errors in calculations are also high along with the doubts on the methodological aspect of data collection and calculation. The frequency of availability of PPP data is also not as frequent as the Market exchange rate. The PPP data also depends on the data availability of prices of various goods and services and is therefore, not available for many countries for which comparison cannot be made. The difference in Market exchange rate and PPP is high for emerging markets because of the basket of non-traded goods not accounted in the calculation of market exchange rate and therefore, the difference in the two indicators matter a lot when analysis involves a emerging economy. As a result, developing countries like India and China, get a much higher weight in aggregations that use PPP exchange rates than they do using market exchange rates. In case of advanced countries like US, the choice of weights makes a big difference in calculations of global growth as compared to the but estimates of aggregate growth.

The prices are higher in developed nations or high-income countries as compared to developing nation. One of the possible explanation for this difference is the difference in productivity of inputs like labor in richer countries because of better technology. This is explained by the ‘Balassa-Samuelson model’ that states that the greater the productivity differentials in the production of tradable goods between countries, the larger the differences in wages and prices of services. This results in a larger gap between PPP and market exchange rate. If cross-country productivity differences are greater in the production of tradable goods than in the production of non-tradable goods, the currency of the country with the higher productivity will appear to be overvalued in terms of PPP.