The Concept of Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is a fundamental economic theory used to determine the equilibrium value of currencies, ensuring that identical goods have the same price in different countries when expressed in the same currency. Essentially, PPP suggests that in the absence of transportation and transaction costs, the exchange rates between currencies should adjust so that a basket of goods costs the same in each country.
The Asian Financial Crisis and PPP
During the late 1990s, the Asian Financial Crisis unveiled the vulnerability of fixed exchange rates, starting with the collapse of Thailand's currency peg in July 1997. This event triggered a regional economic downturn, marked by severe currency devaluations and economic hardship. This blog post explores whether the currencies impacted by the Asian Financial Crisis were undervalued or overvalued, using the PPP model.
Absolute vs. Relative Purchasing Power Parity
To understand PPP during the crisis, we first look at the Absolute Purchasing Power Parity. This concept, derived from the Law of One Price, states that a basket of goods should have the same price across different countries, accounting for the exchange rate. For example:
- If a basket costs $225 in the USA and £150 in the UK, the PPP exchange rate should be 1.50 USD/GBP.
- Similarly, if the same basket costs 800 CAD in Canada and 10,000 MXN in Mexico, the PPP rate would be 12.5 MXN/CAD.
However, during the crisis, these calculations revealed discrepancies, suggesting that currencies like the Japanese yen and the euro were slightly undervalued and overvalued, respectively.
On the other hand, Relative Purchasing Power Parity focuses on price changes over time rather than absolute price comparisons. This version of PPP suggests that the inflation rate differences between countries will be offset by changes in the exchange rate.
The Big Mac Index: A Practical Application of PPP
The Economist's Big Mac Index is a lighthearted yet insightful application of PPP. By comparing the price of a Big Mac across various countries, the index provides a glimpse into whether currencies are overvalued or undervalued relative to the dollar.
For instance, during the peak of the Asian Financial Crisis in October 1997:
- The price of a Big Mac in Thailand was significantly higher relative to the U.S., suggesting an overvaluation of the Thai baht just before the crisis.
Further, analyzing the Big Mac prices from 2000 to 2022 can serve as an informal gauge of inflation in each country. By comparing these price changes to the inflation in the U.S. and corresponding currency value changes, one can visually assess the application of Relative PPP via a scatter plot. This analysis can reveal whether the long-term adjustments in currency values align with changes in relative prices, as PPP theory would predict.
Conclusion
The Asian Financial Crisis provides a profound case study for economists and students alike to explore the complexities of currency valuation and the practical applications of economic theories like Purchasing Power Parity. While Absolute PPP gives us a snapshot of potential currency misalignments at a point in time, Relative PPP offers a broader view of how currencies adjust over the long term in response to inflation differentials.
As global economies continue to intertwine and fluctuate, understanding and applying concepts like PPP remains crucial for predicting financial movements and making informed economic decisions. Whether you're a financial analyst, a policy maker, or just an economics enthusiast, the lessons from the Asian Financial Crisis, viewed through the lens of PPP, are invaluable for navigating the complex world of international finance.