“purchasing power parity”
So I am reading Kiplinger’s and I come across this sentence.
The dollar is far below its “purchasing power parity” (a measure of the greenback’s buying power), which is a good guide to long-term exchange rates.
This term came as a shock to me. What exactly is “purchasing power parity”? I have had long arguments with a Ron Paul supported that insisted that we needed to move back to the gold standard so the US dollar would once again be commodity backed. While I disagreed, I never stated that the dollar had an inherent value, which is what purchasing power parity is implied to be if we are currently well below it.
So what is purchasing power parity (PPP)? PPP states that a basket of goods in the US (country A) should cost the same as the basket of goods in country B after exchanging currencies, assuming efficient markets.
Example: If you can buy a coke at a vending machine for $1 in the US, the same coke would cost £0.50 in the UK, assuming a $2 to £1 exchange rate.
So if this is true, then there are lots of people making a killing on arbitrage opportunities. Again, an example will make more sense.
Siegel from Kilplinger’s is saying that a coke in the US that costs $1 should cost £0.50 in the UK, but in reality the coke in the UK cost’s £0.60. So how do you make money from this?
- Buy $100,000 worth of coke in the US
- Move 100,000 cans of code to the UK
- Sell 100,000 cans of coke for £60,000
- Exchange £60,000 for $120,000
- Repeat until the market equalizes so there is no more profit
So what are the real numbers? The exchange rate is $1.94729 to £1 and the PPP is $1.49254 to £1 (2006 numbers).
My 100,000 cans of coke cost $100,000 and sell for £67,000 returning $130468.43 for $30468.43 in profit. At over 30% profit, it takes less than 3 cycles to double your money.
So there is MAD money to be made, what is going to equalize the difference? The dollar will rise against the pound OR inflation will raise the prices of US goods in dollars to match that of UK goods in pounds. Until then, this should be good for the US economy, since we are apparently holding a country wide sale of 30% off anything made in the US. Airbus must hate that.