Unit - 5

Inflation

5.1 Price index, Inflation: Meaning, types, causes, measurements and effects, Inflation and determination of interest rates, Measures to control (REPO rate C.R.R.)

Overview

The consumer price index usually focuses on the goods and services that households buy. The Producer Price Index focuses on the goods purchased by the company. GDP chain-type indexes measure price fluctuations throughout the economy. To know the index, we best know what the price index is, how it is constructed and how it is interpreted.

The price index is a measure of price change using the percentage scale. The price index is often supported the worth of one item or a gaggle of selected items called a market basket. For example, hundreds of goods and services are used to calculate the consumer price index, such as rent, electricity, and cars. Because the market basket contains a variety of products and services, it provides a more comprehensive measure of inflationary pressure than a single product.

Editing and using the price index:

We know that goods and services are valued in terms of cash. Their prices indicate their relative value. As the price goes up, the amount you can buy for a certain amount goes down. The lower the price, the more money you can buy. In other words, the lower the price, the higher the value of the money. As the price goes up, the value of money goes down.

The index number is a statistical device used to represent price fluctuations as a percentage of the price in the base year (or base date). (This base date is indicated by a phrase such as "1980 = 100".) In this case, price fluctuations are expressed as the rate of change relative to the 1980 average level.

India has a variety of price indexes, including retail price index, wholesale price index, industrial worker living cost index, and export price. Individual index numbers can be calculated to measure changes in each price level. However, the construction method is the same in both cases.

Index numbers are easily created by selecting a group of products, recording the price for a particular year (base year), and adding 100 to the total. If the price of the selected item rises by 3% the following year, for example, the index number at the end of the year will be 103. A 1% price drop is indicated by index number 99.

There are two relevant points to note in this context.

1. Value of money:

First, wholesale and retail commodity prices are not only different, but can move in different directions at different rates at once. Therefore, there is no such thing as "value of money". We must think about the value of money in a particular use or in various areas of the economy.

2. Small selling price movements:

Even within a particular sector, such as the retail sector, the price of each item varies from place to place and from different shops in the same town. In addition, different people buy different things, and even if they buy the same thing, the quantity they buy will be different.

Therefore, it is not appropriate to treat a decline in the average retail price of money as a "rise in living expenses." It just means that the cost of certain parts of society living a normal life has risen. Families in other sections of society may have experienced a more or less rise. Or you may even have experienced a decline in living expenses.

3 steps:

Creating a retail price index involves three steps. First, you need to decide which section of the population to cover in the index. Then you need to know how the family involved is spending money. Finally, you need to select the base year of the index.

1. Which section of the population?

This depends on the acquisition that the index is employed. If it is used to regulate old-age pensions, the basis of the calculation must be the pattern of old man's spending. When using indexes to assess the well-being and economic progress of the entire community, we need to collect information from different people (that is, people of all classes). Eliminating the very rich and the very poor is in the lightness of things. Because their spending patterns are very different from other societies, and when included, they overly distort the average situation.

2. What is the average spending pattern for the selected group?

This can be seen by investigating family spending within the group. A random sample of the family should declare all the details of spending in a randomly selected week throughout the year. Based on this information, the average pattern of spending is calculated.

3. What is the base date (year)?

It is important to consider the normal year when determining the base date for the index (which should be as average as possible for the study period). Exceptional years such as wars, emergencies, and revolutionary years should be avoided. This is due to certain factors affecting wartime prices the future (time of peace).

Basic equation:

The formula for calculating the index number for a particular year is:

Rupee Expenditure for a Specific Year / Rupee Expenditure for Base Year x100

= Price index for a particular year.

For example, Rs in the 4th year. You need 600 to buy what rupees. I bought 500 in the base year. If you put these numbers into the equation, you get.

Rs. 600 / Rs. 500 x 100 = 120.0.

Importance of index:

The consumer price index and other inflation indicators are not curiously studied by scholars, businessmen and government officials. Rather, indicators have a significant impact on policymaker decisions and economic operations. They directly affect the wages of union workers whose living expenses are adjusted based on the consumer price index, and also affect the size of payments for many non-union incomes.

Employers and employees often look to these indicators when deciding on a "fair" salary increase. Some government programs, such as Social Security, change their monthly checks based on one variation of these indexes. Private business contracts may offer price adjustments based on the producer price index, and in some cases other payments such as parenting and rent are associated with one of these indexes.

By comparing the indexes for several consecutive years, you can see whether the price level is rising or falling and the degree of change. The government can then take appropriate steps to counter the negative effects of price fluctuations in either direction.

The cost-of-living index can be used to determine the status of the working class. In some countries, wages fluctuate in proportion to changes in the learning cost of the index so that workers do not suffer as prices rise.

The index number helps you compare the price situation of one year with the price situation of another year. For example, the 1939-1945 index shows how price levels and the value of money have changed during these years. However, do not make long-distance comparisons. It makes no sense to compare the 1939 index number with the 1999 index number.

The reason is that many new products were born in 1999, and most of the 1939 products still in use in 1999 have undergone significant changes in quality. If the time interval is too long, there is no common base for comparison. This also applies to index numbers in different countries.

Inflation: Meaning, Types, Causes, Measurements and Effects

Inflation is the rate at which the general price level of goods and services rises, resulting in a decline in the purchasing power of the currency. Central banks are trying to limit inflation and avoid deflation in order to keep the economy running smoothly.

Inflation is the continuous rise in the general price level of goods and services in the economy over a period of time. As price levels rise, less goods and services are purchased by each unit of currency. As a result, inflation reflects a decline in purchasing power per unit amount. This is a loss of real value in exchange media and unit accounts within the economy. The main indicator of price inflation is the inflation rate. This is the annual rate of change of the general price index (usually the consumer price index). The opposite of inflation is deflation.

Inflation affects the economy in a variety of positive and negative ways. The negative effects of inflation include increased opportunity costs for holding money and uncertainty about future inflation that can discourage investment and savings. If inflation is fast enough, consumers are in the future. The positive effects are reducing the real burden of public and private debt, keeping the nominal interest rate above zero so that the central bank can adjust interest rates to stabilize the economy, and unemployment due to nominal wage rigidity. Includes reductions. Economists generally believe that high inflation and hyperinflation are caused by the overgrowth of the money supply. There are more diverse views on the factors that determine low to moderate inflation. Low or moderate inflation can result from fluctuations in the actual demand for goods and services, or changes in available supplies such as shortages. However, the consensus is that the long-term duration of inflation is driven by the money supply, which grows faster than economic growth.

Inflation is a quantitative measure of the speed at which the average price level of a basket of selected goods and services in an economy increases over a period of time. it's the constant rise within the general level of prices where a unit of currency buys but it did in prior periods. Often expressed as a percentage, inflation indicates a decrease within the purchasing power of a nation’s currency.

According to A.C. Pigou (Cambridge University), inflation comes in existence “when money income is expanding more than in proportion to income activity”. An increase in general price level takes place when people have more money income to spend against less goods and services.

G. Crowther (British economists) brings out the meaning precisely when he says, “inflation is a state in which the value of money is falling i.e., prices rising”.

Inflation, according to Harry G. Johnson (Canadian economist), “is a sustained rise in prices”.

Paul Samuelson (American economist) defines inflation as “a rise in the general level of prices”.

According to Milton Friedman (American economists), ‘inflation is taxation without representation’.

Causes of inflation

This is a general explanation given by the Keynesians. Inflation occurs when the aggregate demand for goods and services in the economy rises faster than the economy's capacity. Inflation, in the opinion of monetarists, is simply caused by the money supply, which controls all other factors that determine inflation. The economy is such a big theme that there is no absolute explanation for how inflation is being injected into the world economy. I've read an article about Forbes and I think the author has a very good explanation for this topic.

Inflation is primarily caused by either the demand-pull factor or the value push factor. aside from supply and demand factors, inflation also can be caused by structural bottlenecks and policies of governments and central banks. Therefore, the most causes of inflation are:

How to calculate inflation

Due to the different price indexes, different inflation indicators are used. A simple formula to calculate inflation is to use the Consumer Price Index (CPI). It simply measures nominal consumer prices.

There are platforms that can calculate the value of money. I'm playing with a calculator and it's based on the Indian CPI: -

"The cost of 1000rs in 2004 is the cost of 1239.91rs in 2014, and if you buy the exact same product in 2014 and 2004, it will cost 1000rs and 793.24rs, respectively."

From here, you can see that inflation is devalued your money if you do nothing about it.

Types of Inflation

Demand- Pull Inflation

Increase in Money Supply: When the monetary authorities increase the money supply in excess of the supply of goods and services it results in additional demand and consequent increase in price level. As Milton Friedman put it “inflation is always and everywhere a monetary phenomenon”.

Deficit Finance: As increase in money supply also takes place when the government resorts to deficit financing to incur the public expenditure. Deficit financing undertaken for unproductive investment or expenditure becomes purely inflationary. Even when it is used on productive activities, prices would still increase during the gestation period.

Credit Creation: Commercial banks increase the quantity of money in circulation when they advance loans through credit creation. Credit creation is similar to that of deficit financing in its effects.

Exports: Exports reduce the goods available in domestic market. Export earnings enhance the purchasing power of the exporters and others linked with export. An increase in exports would aggravate the situation by reducing the supply of goods and at the same time pushing up the demand because of additional income.

Repayment of Public Debt: Public debt is a common feature of modern governments. When such debts are repaid, people will have more income at their disposal. Additional disposable income tends to raise the demand for goods and services.

Black Money: Social and economic evils like corruption, tax evasion, smuggling and other illegal activities give rise to unaccounted (for tax payment) or black money. People with black money indulge in extravanza, affecting demand and thus the price level.

Increase in Population: The size of the population is one of the important determinants of demand in many developing countries population is large in size and still increasing. India provides an example where demand outstrips supply due to the large and increasing population.

Cost- Push Inflation

Inflation need not necessarily be due to an increase in demand but increase in cost. Increase in the prices of inputs including labour, increase in profit margin by the business firms and monophony in factor market may push up prices as they influence the supply price.

The important cost push factors are:

Increase in wages: When prices increase due to increase in wages it is called wage-push inflation. Wages are influenced by many factors besides the demand and supply forces. Trade unions play an important role in deciding the wage rate. Strong and powerful trade unions succeed in securing higher wages for their members. Higher wages granted in the organised sector influencing the wage rate in the unorganised sector too, resulting in an increase in cost everywhere.

Increase in Material cost: Prices of materials used in producing goods constitute a significant part of the cost. Prices of the materials may increase either due to an increase in demand for these materials or independently owing to national and international developments. Increase in crude oil price till recently is an example in this context. When the prices of basis inputs like energy, cement, steel, etc. increase, the effect is felt throughout the economy. An increase in the prices of materials especially the basic inputs alter the cost structure of all goods and services. Higher the cost of production leads to upward revision of final prices.

Increase in Profit Margin: Firms operating under oligopoly or enjoying monopoly power (petroleum firms in public sector) may have ‘administered prices’ with higher profit margins. Such administered prices though imposed by few firms, have their impact on other firms too. The desire to have higher profit margins by all those who have the power to do so becomes the cause for inflationary trend.

Other factors: Cost of production may increase when input prices go up due to scarcity – natural or artificial. Natural calamities like draught or floods adversely affect supplies of raw materials thus making them dearer. Firms operating with excess capacity either because of monopolistic competitive market or any other reasons, produce at a higher cost.

Stagflation: The most important difference between demand-pull inflation and cost-push inflation is that demand-pull inflation does not reduce the production of the economy as a whole. On the other hand, in the case of cost-push inflation, as prices rise, so does the production level of the economy.

Declining production will reduce employment in the economy as growth declines. The slowdown in growth associated with higher prices makes cost-push inflation more dangerous than demand-pull inflation. The situation of rising prices due to growth and declining employment is called stagflation.

Hyperinflation: Hyperinflation is a situation in which inflation rises at a very fast rate. Inflation can increase from 50 to 300 times.

The effects of hyperinflation can have a devastating impact on the economy. This situation can lead to a complete collapse of the currency value of the economy, along with an economic crisis, increased external debt, and reduced purchasing power of money.

The main causes of hyperinflation are: The government has issued too many currencies to cover the deficit. War and political unrest, and an unexpected increase in people's expectations of future inflation.

When people anticipate future inflation to rise at a very fast pace, they will begin to consume more goods and services, fearing that higher inflation in the future will destroy the purchasing power of money. As a result, demand for goods and services will increase and further inflation will accelerate. This cycle continues, leading to a hyperinflationary scenario.

Structural inflation

Structuralist inflation is another form of inflation that is predominantly prevalent in developing and low-income countries.

Structural schools argue that inflation in developing countries is primarily due to weak economic structures.

They further argue that rising money supply and government spending can only partially explain the inflation scenario.

Structuralists argue that the economies of developing countries such as Latin America and India are structurally underdeveloped and very volatile due to the existence of weak institutions and the imperfect working of markets. I will.

As a result of these deficiencies, some sectors of the economy, such as agriculture, will witness supply shortages, while some sectors, such as consumer goods, will witness excessive demand. Such economies face the problems of both supply shortages under the use of resources and excessive demand in some sectors.

Example: In India, suppose a farmer produces fruits and vegetables at 10,000 per quintal. But the end consumer will be the same at 20000 per quintal. The big gap between what farmers receive and what consumers pay is due to infrastructure and agricultural bottlenecks. Bottlenecks are primarily due to shortages of roads, highways, cold chains, and underdeveloped agricultural markets. All of this increases the cost of transporting goods from farmers to consumers, leading to inflation.

Measurement

Inflation measurement in India

There are two main sets of inflation indexes for measuring changes in India's price levels. The Wholesale Price Index (WPI) and the Consumer Price Index (CPI). WPIs whose prices are estimated by wholesalers are built by the Ministry of Commerce and Industry's Bureau of Economic Affairs. In the case of CPI (Price Estimated by Retailers), there are several indicators to measure it: In addition to all Indian CPI, Industrial Workers (CPI-IL), Agricultural Workers (CPI) -AL) and CPI of local workers (CPI-RL).

In addition, the National Accounts (NAS) Gross Domestic Product (GDP) deflator and the Private Final Consumption Expenditure (PFCE) deflator provide an implicit economic-wide inflation forecast.

Consumer Price Index

Two Ministry – The Ministry of Statistics and Program Implementation (MOSPI) and the Ministry of Labor and Employment (MOLE) are working on building different CPI for different groups / sectors. CPI inflation is also known as retail inflation because prices are estimated by retailers. Below are the various CPI.

(A) Total of all Indian CPI or CPI.

(B) Agricultural Worker (AL) CPI

(C) Rural workers' CPI (RL); and

(D) CPI (IW) of industrial workers

(i) CPI (CSO) by MOSPI

CSOs under the umbrella of MOSPI build rural, urban, and complex CPI. Published since 2011. Of these, the combined CPI is the most important of all CPI because it is relevant to people in all categories.

In April 2014, the RBI selected the All-India CPI (of the CSO) as the inflation index for inflation under the new inflation targeting the monetary policy framework. The RBI's decision has made the CPI the leading inflation index.

 (ii) CPI (Labor Bureau) by MOLE

The Ministry of Labor and Employment (MOLE) Labor Department prepares different indicators for different categories of people. These were the CPI for rural workers (CPI-RL), the CPI for agricultural workers (CPI-AL), and the CPI for industrial workers (CPI-IW). There was a CPI (CPI-UME) for non-manual employees in urban areas, but it was abolished in April 2010.

These CPIs were for certain categories of workers and therefore lacked the quality of the All-India Index.

Effects

Impact of high inflation

The obvious consequence of high inflation is that it makes it more difficult for people to buy basic necessities such as batteries and light bulbs. This makes families struggle to keep up with everything from cornflakes to college tuition.

Beyond the basic effects of inflation, there are two major effects of inflation.

Loss of Purchasing Power: The impact of inflation on savers and investors is the loss of purchasing power. Whether you're burying money in a coffee can in your backyard or sitting in the safest bank in the world, it loses value over time. This can create an incentive to spend money, and under the wrong conditions, it can create an incentive to invest money in something that is good for civilization in the long run.

Impact on fixed payers and beneficiaries: The impact of inflation on debtors is positive because debtors can pay their debts with low-value money. For example, if you borrowed $ 100,000 at 5% interest and inflation suddenly surged to 20% per year, you're effectively monitoring the repayment of 15% of your debt each year.

Both of these can interfere with many mechanisms of the economy. Loss of purchasing power can lead to lower consumer spending. With low consumer spending, businesses will suffer a loss of revenue. In addition, companies can suffer as the costs of goods and services needed to run their businesses increase. As it increases, they are in a position to raise prices. If their income has already been hit by lower spending, raising prices will only exacerbate the problem. If companies are struggling, they reduce wages and the number of employees. As a result, the unemployment rate can rise.

Impact of low inflation

There are many negative consequences of high inflation, but that does not automatically mean that low inflation is positive for the economy. Low inflation can have many negative effects on the economy.

It shows the weakness of the economy: the lack of inflation can be caused by the lack of demand for goods and services. When demand is scarce, there is no pressure to raise prices. Soft On Demand can slow growth and push wages down, which further exacerbates the effects of low inflation. This can cause a dangerous economic feedback loop.

Limiting the Impact of Monetary Policy: In the event of a recession or slowdown, one of the means central banks pull to revitalize the economy is to lower interest rates through monetary policy. If inflation is low, interest rates may already be low. If interest rates are low, central banks cannot make a significant impact through interest rate cuts.

Low deflationary buffer: If inflation is low, it means that it is not only close to zero, but also close to negative. Negative inflation is called deflation, which is a condition in which the economy does not want to enter. Deflation reduces consumer confidence and reduces demand, prices, wages and more. Five

Putting pressure on the financial system: A functioning financial system is the backbone of a functioning economy. Imagine you are a bank and make money with a spread between the cost of borrowing and the income from lending. If inflation is low, the spread will decrease. In other words, the rate of return drops, and in some cases even negative. When this happens, the lender becomes more worried about lending, so the money can be tightened.

Inflation and Determination of Interest Rates

The relationship between inflation and interest rates.

To understand the relationship between inflation and interest rates, we need to understand the difference between real and nominal interest rates.

Return to basics: As an example, if you decide to deposit all your money (Rs 1 Lakh) in a bank as a fixed deposit, the bank will pay an interest rate of 10%. The interest rate paid by the bank is the nominal interest rate. According to this logic, it is expected to earn Rs 10,000 as interest on fixed deposits in one year. In the second year, 110,000 rupees will be credited to your bank account.

But what about the value and purchasing power of your deposits? Is Rs 1,10,000 worth of money enough to buy the same basket items that I bought last year? Rs 1,10,000 will buy you the same amount of commodities, less or more commodities all depend on the inflation rate of the economy.

For example, the inflation rate of the economy during the period is 20%. What is the value of deposits at 20% inflation?

The actual value of a product that can be purchased from Rs 1,10,000 is actually much lower than it was a year ago. A basket of goods, which was 10,0000 rupees in the previous year, now costs 120,000 rupees. But the bank only pays you Rs 1,10,000. Bank interest rates couldn't beat inflation in the economy. Therefore, the post-inflation-adjusted real interest rate paid by banks on deposits is actually minus 10%.

Real interest rate = Nominal interest rate – Inflation rate.

-10 = 10 – 20

Different Price Index in India

The first three indicators, on the other hand, relate to a particular occupation. CPI edited and released at the national level by MOLE is associated with specific domestic demographic segments such as industrial workers (CPI-IW), agricultural workers (CPI-AL) and rural workers (CPI-RL). It reflects fluctuations in the retail price.

What is the difference between the different CPIs?

The difference between different CPI is not just to measure changes in price levels in different sectors or groups. In addition to these sector-specific price level measurements, these indicators serve as a basis for comparing geographic range, included products, weights assigned to different product groups, and price level changes. It differs in that.

2. Wholesale Price Index (WPI)

WPI is issued by the Economic Advisory Bureau of the Ministry of Commerce and Industry. It has been in use since 1942 and has been published regularly since 1947. It has a long history of serving as a national inflation indicator until the emergence of the Consumer Price Index in 2011.

Measures to control (REPO rate C.R.R

How to overcome inflation

If we just live and do nothing about it, our purchasing power declines every day. Below are some suggestions on how to overcome inflation.

 First, we need to lower our standard of living by buying less expensive ones.

2.     Invest for better returns.

 Simply put, in order to overcome inflation, you need to learn how to work harder and get higher returns. Inflation is a silent killer that eats us every day. We need to be prepared for it, or you will see your standard of living fall down, and it will be too late to take action.

3.     Be careful about holding cash.

 Nevertheless, putting money in a bank account that earns a 5% interest rate is worth 5% less at the end of the year.

4.     Do not take long-term fixed interest rate loans.

 Do not buy bonds until the end of the inflation period. High inflation completely destroys the value of long-term bonds. Of course, some people apply for a bank loan with a good fixed rate of 4% and are retained as the interest rate rises to 14% over time. Be careful before applying for a bank loan, check interest rates and choose a good long-term loan that will not cause a big loss.

5.     Invest in gold, silver, etc.

In some countries, real estate may be ideal for investment, but not all. Please check before creating.

6.     Online business

Looking at the size of the Internet economy, it is important and the world is moving towards the digital world. That's why more and more online shopping platforms are a way for business people to reach out to consumers.

Key takeaways:

5.2 Foreign Exchange Rates: Fixed vs floating, P-P-P theory and current practices to decide exchange rates.

An exchange rate is the value of one currency and another, or the price you pay in your local currency to buy a fixed amount in another currency. However, to make it a little more complicated, there are two types of exchange rates, fixed exchange rates and floating exchange rates, and it is important to know the difference so that the information can be used wisely.

What is a fixed exchange rate system?

Fixed exchange rates, also known as fixed exchange rates, represent when the value of a currency is fixed relative to the value of one or more other currencies. This means that if you make multiple exchanges between these currencies, you will always get the same exchange rate and therefore the same amount of value.

Governments typically fix exchange rates to stabilize their currencies and make financial and trade transactions consistent and predictable. But that also means that as the value of fixed currencies goes up and down, the value of their currency goes up and down.

Some governments want to spread the risk of changing the value of one currency by fixing it to a basket of multiple currencies at different rates. So, for example, the currency may be fixed at 50% to the British pound, 30% to the euro and 20% to the dollar. This means that their currency is less at risk of being converted to one other fixed currency.

What is a floating exchange rate system?

The floating exchange rate system, also called the floating exchange rate system, changes according to supply and demand. That is, if the demand for a currency is low or widely available, its value will decline, and conversely, if it is in demand or in short supply, its value will rise and the exchange rate will accompany it. Will also rises.

The supply and demand of currencies is affected by various factors such as international trade, interest rates, and foreign investment. Each of these can have a significant impact on the value of a currency in the international market. For example, if a country receives a lot of investment from foreign companies, the demand for that currency will increase, resulting in increased value and exchange rates.

The International Monetary Fund states that being driven by floating exchange rates is a sign of a country's financial maturity, but some countries use a managed float approach to border between fixed and floating exchange rates. I like to straddle. That is, we use a floating exchange rate system, but only to the extent that the government can intervene and take action if the exchange rate is too low or too high.

Which is better, fixed exchange rate system or floating exchange rate system?

Perhaps, of course, both have their strengths and weaknesses, and which one is best depends largely on the particular financial situation of a particular country.

Advantages and disadvantages of fixed rates

The big advantage of fixed rate is stability, straightforwardness and simplicity. By fixing the currency to a strong and stable currency such as the dollar or the euro, you can reduce the risk of sudden changes in the value of a country's foreign income or foreign investment and reduce inflation. This can promote international trade and help economic growth. As a result, many developing countries in Africa follow a fixed route.

The downside of fixed rates is the amount of effort needed to keep them down. Central banks need to constantly monitor the market and intervene to prevent economic changes from overwhelming the market. Usually, you buy and sell currencies. However, this can be very expensive and, if not properly managed, can put the country at risk of economic crisis.

Advantages and disadvantages of floating interest rates

Unlike the fixed exchange rate system, the floating exchange rate system moves up and down independently based on changes in market interest rates and supply and demand. This means you don't have to monitor or manage it, freeing up valuable resources, increasing the flexibility of your internal policies, and significantly freeing you from the complex legislation designed to regulate cash flow and reserves.

But at the same time, floating rates bring much more uncertainty. It exposes the country to larger (sometimes dangerous) fluctuations in exchange rates, which discourages foreign investors and traders and makes already weakened economies more susceptible to rising international costs and volatile markets. There is a possibility.

Both Fixed and Floating exchange rates have their own merits as mention below:

P-P-P theory and current practices to decide exchange rates.

What is Purchasing Power Parity?

Purchasing power parity (PPP) is the economic theory of exchange rate determination. It states that price levels between the two countries must be equal.

This means that when currencies are exchanged, the prices of goods in each country will be the same. For example, if the UK Coca-Cola price is £ 100 and the US price is $ 1.50, according to PPP theory, the GBP / USD exchange rate will be 1.50 (US price divided by UK price). Become.

However, looking at the market exchange rate for the GBP / USD pair, it is actually close to 1.25. Differences occur because the purchasing power of these currencies is different. Like any other asset, it has the actual value of the currency and the assumed value that the financial markets trade. The purpose of the PPP measurement is to make the comparison between the two currencies more effective by adjusting for differences in local purchasing power.

PPP measures are widely used by global institutions such as the World Bank, the United Nations, the International Monetary Fund and the European Union.

Economic theory is often divided into two main concepts:

Absolute purchasing power parity

Relative purchasing power equivalence

1. Absolute parity

Absolute Purchasing Power Parity (APPP) is a basic PPP theory, stating that when two currencies are exchanged, a basket of commodities should have the same value. The theory is usually based on converting other world currencies to the US dollar.

For example, if the price of a Coca-Cola can is $ 1.50, APPP proposes to convert the US dollar to the local currency and then set the price of a Coca-Cola can in another country to $ 1.50.

If this is not the case, APPP suggests that the exchange rate will change over time until the goods are of comparable value. Without trade barriers, commodity prices should be in equilibrium. This is a completely price-level theory, looking only at the exact same merchandise basket in each country, without any other factors.

However, this theory ignores inflation and personal consumption, as well as the presence of shipping costs and tariffs, which can affect short-term exchange rates. Without these inclusions, the power of currency would not be fully expressed.

2. Relative Parity

Relative Purchase Power Parity (RPPP) is an extension of APPP and can be used in combination with the first concept. While arguing that the value of the same good in different countries should be equal over time, the RPPP suggests that there is a correlation between price inflation and the exchange rate. It looks at the amount of goods or services that a unit of currency can buy. This can change over time as inflation changes. Inflation, in theory, reduces the real purchasing power of a currency, so inflation must be taken into account in order to properly adjust PPP.

For example, if the UK's annual inflation rate is 2%, then £ 1 of £ 1 will be 2% less per year.

Adding this concept to APPP shows that inflation is part of the change in currency power. So, suppose the UK has an inflation rate of 2% and Brazil has an inflation rate of 5%. So, a year later, the price of a Brazilian merchandise basket has risen by 5%, while the price of the same merchandise basket in the UK has risen by only 2%.

PPP calculation method: PPP formula

The official PPP calculations depend on what you are trying to achieve and which PPP you want to use.

Absolute purchasing power parity is calculated by dividing the cost of a good in one currency by the cost of a good in another currency (usually the US dollar). Then, to calculate the relative purchasing power parity, simply assume the ratio. The price level is equal to the exchange rate from one currency to another and is adjusted for inflation. This gives you an estimate of the depreciation rate of one currency compared to another and future exchange rates.

Purchasing Power Parity Limit

Purchasing power parity theory relies on the idea of   arbitrage. This is an opportunity to buy an item in one place, sell it quickly in another place at a higher price, and take advantage of the price difference. This balances the price between buying and selling, and eventually the price converges. However, in reality, transaction costs, government taxes, and trade barriers prevent cost levelling.

The theory also relies on the baskets of merchandise being exactly the same or, at best, very similar merchandise. To make a truly meaningful comparison, your basket must contain a variety of goods and services. The amount of data that financial institutions have to collect is enormous and can be a complex process. For example, the United Nations International Comparison Program (ICP) and the University of Pennsylvania has examined 1000 products in each of the 147 countries that participated in the program.

Key takeaways:

References:

1. “Modern Micro Economics”, Koutsoyiannis.

2. “Fundamentals of Engineering Economics”, Park, Prentice Hall.

3. “Economics”, Samuelson.

4. “Growth Economics”, Sen A.K, Penguin Books, England.