Exchange Rates: Purchasing Power Parity

Alright now let's discuss the theory of purchasing power parity. So purchasing power parity P. P. P. States that exchange rate. So this theory says that exchange rates will move to equalize the purchasing power in different currencies. This is basically saying that you should be able to buy the same amount of goods with equal amount of money in different countries. Right? So if you have $1 in the U. S. You should be able to buy the same amount of stuff as if you were to exchange that dollar for a foreign currency and buy stuff in that foreign country. That's the purchasing power parity. So let's go through an example here to see how it works. So let's say the exchange rate let's keep it simple is £1 to $1 right? One great british pound for $1. And the price of a coke is $1 in the US and £1 in the U. K. Well we have purchasing power parity in this situation because of this. If we take the $1 in the US we can buy one coke. Right now we take that $1 to the U. K. And we exchange it for £1. Let me see if I can draw this little symbol. £1. That wasn't too bad. And you can get one coke right with you, exchange it for £1 and then you get one coke. So they have equal purchasing power right? Regardless of where you are, that same dollar gets you the same amount of stuff. Okay now let's change it up a little bit. Let's say the exchange rate stays the same, £1 for $1. But now the price of a coke is $1 in the U. S. But £2 in the UK. Okay, so now the price has changed in the U. K. To £2 for the coke. Right? We don't have purchasing power parity here. They're going to be different because notice you can take the $1 in the U. S. And the price is $1. So you get one coke. Now you go to the U. K. And you try and do the same thing, You take the $1 and you get one £1 and now you try and buy a coke and they say, hey coke is £2 here. I don't know what you're trying to do with this £1. So you only get half a coke in the U. K. Right? Because you need £2 for a full coke, you only get half a coke. So they have different purchasing powers now. Right? And this doesn't follow purchasing power parity above, we have purchasing power parity because one coke, that $1 can get you a coke regardless of where you are. Now, that $1 doesn't go as far in the UK. So what would need to happen to the exchange rate for this to to still have parity here. What we would need to be able to get £2 per dollar. Right? We would need to be able to get £2 for your $1 to keep purchasing power parity, right? Because if we had been able to exchange £2 right? If we were able to take our $1 Exchange it for £2, well now that £2 can buy you one coke, right? And we would have purchasing power parity again. So you could buy a coke in the U. S. For $1. Trade the $1 for £2 and then by one coke in the U. K. Just like we saw there. So in that situation now we have purchasing power repaired again. Now the dollar, the pound have uh equal purchasing power again and we have purchasing power parity in that situation. However if the exchange rate does not adjust for the change in the price levels, if we don't see that exchange rate adjust well then there's an opportunity for profit. Okay and this is what leads back to purchasing power parity. So let's look at this example, let's go back to the situation where there's $1. £1 equals $1 and the prices are $1.02 pounds again. Right? So there's not purchasing power parity. Um You can't get as many cokes in the U. K. With your dollar. So this is what you could do to make some quick easy profit. Easy peasy profit right here. Okay this is this is the value really getting out of this lesson right here is how are you gonna make all this money out of purchasing power parity? Using arbitrage? Alright, so let's check it out. You buy one million cokes for $1 million in the US, right? Each coke is $1 you go out and you buy one million cokes. Okay, now you take those cokes to the U. K. Let's say there's no shipping costs, you just take those cokes over to the U. K. And you sell those one million cokes for £2 million right? Because the price is £2 over there, so you're gonna get £2 million easy peasy, right? You take those £2 million from the U. K. And you trade them at that exchange rate £2 million for dollars and you end up with $2 million just like that. You started with $1 million you ended with $2 million. Right? So that's the whole thing with purchasing power parity is if these if these exchange rates don't line up there exists this this possibility for profit, of course there will be some shipping costs, but the idea still remains there in theory. Right? So as many people attempt this scheme, people start to see this value scheme here and they all start to to buy the dollars um to to to buy the cokes and do this scheme right here. Well, they would bid up the price of the dollar, right? Because everyone's trying to buy dollars to buy the cokes at this cheaper price, Right? And sell them at the higher price in the UK. Well, this would increase the demand, right? The demand would increase for the dollars. And we would end up back at purchasing power parity eventually. Right? This would increase and increase all the way up until we reach the equilibrium exchange rate, which would be that £2 per dollar. And then we would have purchasing power parity again. Okay, so that's the whole idea of purchasing power parity. Is that the value of goods that you should get should be the same regardless of where you are, based on the amount of money you have. Alright, so let's pause here and let's talk about some of the issues with the purchasing power parity theory. In the next video

So purchasing power parity attempts to explain these changes in exchange rates, why they go up and down to keep these prices constant across countries. However, it's not a complete explanation of exchange rates because of real world issues that we see first. Not all products can be traded internationally, like doctors services, right? You can't buy a us doctor visit from great Britain or something, right? You can't just buy it from another country like that. They can't be bought in one country and sold in another. No Doctor service is not traded internationally. Second, there's consumer preferences. Maybe consumers like coke more in one country than in another country, Right? So they may be willing to pay a higher price. They may be willing to pay a higher price for a certain product in one country than in another country. And finally, barriers to trade. So barrier to trade would be something that's stopping trade from happening freely and import import quota, which is a government mandated maximum. They say, Hey, you can't import a million cokes here. There's only, there's a law that says only 500,000 cokes can come in per year. Right? So there's this import quota that happens or a tariff, a tariff is just a tax imposed on imports. So every time you try and import something, you got to pay a tax and that impedes on the free market, right? When you have to pay these taxes. Okay, So these issues come into play and they don't always allow purchasing power parity to exist in the real world application. Alright, So that's about it here. Let's go ahead and pause and we'll move on to the next video.