| | | | | | shrinks, eventually by enough to cause forces for change to arise. Thus, by looking at inflation differences, more confidence can be placed in the PPP prediction, at least insofar as the long-run picture is concerned. | | | | | | | | | 17.4
The PPP Exchange Rate | | | | | | | | | A traveler also might notice that prices of nontradables such as haircuts and hotel rooms can differ markedly from country to country, at times by amounts dramatically different from what PPP would imply. Because PPP only applies to tradables, this phenomenon is not anomalous, but it does suggest that the exchange rate can be misleading if used to calculate cost-of-living comparisons. | | | | | | | | | Suppose you have been offered a job in France paying 160,000 francs per year. You check the newspaper, find that the exchange rate is five francs per dollar, and quickly calculate that this amount is equal to US$32,000. It would be a mistake to compare this figure to your current salary in the United States, because it may be that the cost of living in France differs markedly from the cost of living in the United States. To make a fair comparison, you would have to find out how much it would cost you to live your current lifestyle in France. | | | | | | | | | The real problem here is that the exchange rate does not reflect cost-of-living differences between countries. Instead, it reflects the forces of supply and demand for the dollar in the foreign exchange market, determined by the relative costs of tradables and by a variety of other factors (such as interest rate differences). To make cross-country cost-of-living comparisons, we need a different exchange rate, one explicitly designed to tell us the purchasing power of a franc in France compared to the purchasing power of a dollar in the United States. | | | | | | | | | The PPP exchange rate does just that. It is calculated by taking the ratio of the cost of a typical bundle of goods and services in francs in France to the cost of that same bundle in dollars in the United States. Formally, it is calculated as follows: | | | | | | | | | If the ratio is four, then the PPP exchange rate is four francs per dollar, so the 160,000-franc salary, in terms of its purchasing power in France, is equivalent to US$40,000. An innovative, albeit extreme, way of measuring the PPP exchange rate has been developed by the Economist magazine through checking the cost of a Big Mac in different countries. If, for example, a Big Mac costs eight francs in France and two dollars in the United States, the PPP exchange rate is four francs per dollar. | | | | | | | | | Using this alternative exchange rate to make cross-country comparisons can make a big difference. Recently, the International Monetary Fund calculated world income shares using purchasing power parity exchange rates instead of current exchange rates. The result vastly boosts developing countries' share of the world's GDP to 34.4 percent from 17.7 percent. The explanation for this result is that the PPP exchange rate accounts for the fact that many | | | | |
