Purchasing Power Parity

Long term equilibrium exchange rates are driven by purchasing power parity, which relates the purchasing power of currencies in different countries through relative prices. If $100 purchases a representative basket of goods in the United States and 100 monetary units (MU) buy a representative basket of goods in a foreign country, then the long term equilibrium exchange rate between the two currencies should be 1:1. If the 1:1 ratio were not true, then there would be a flow of goods from one country to the other to take advantage of the bargain, within transportation and other costs.

Now suppose that in ensuing years, there are productivity increases and price changes due to inflation in the United States that, when balanced out, reduce the cost of the representative basket of goods to $70, while in the foreign country there are productivity increases and inflation that reduce the cost of a representative basket of goods to 90 MU. The long term equilibrium exchange rate would then float from the previous 1:1 to 7:9, or $1 would exchange for 9/7 = 1.29 MU of the foreign currency.

The movement of exchange rates is controlled by the relative productivity improvement and inflation of the two economies, represented by aggregate price levels. Fore example, if the 1960–1980 average productivity improvements in the United States and Japan of 3.0 and 9.4 percent, respectively, were compounded over that 20 year period aggregate US productivity would be 1.80 times its initial level, compared to 6.72 times the initial level in Japan; that is, if the initial indexes of productivity were both 100, the 1980 indexes would be 180 for the United States and 672 for Japan.

The relative influence on prices in the two countries would be in relation to these productivity improvements. If inflation were the same in both countries, then the relative price changes would reflect only the influence of productivity improvement. But if inflation averaged 4 percent in the United States and 3 percent in Japan for the 20 year period, then the relative prices would reflect a net inflation in the United States averaging 1 percent (4 percent inflation minus 3 percent productivity increase), whereas the Japanese would enjoy the net effect of a 6.4 percent average productivity inflation change in price levels. Over the 20 year period, the relative price changes would be reflected in exchange rate adjustments because the purchasing power of the two currencies would have changed. Of course, there may be short term policies that move exchange rates from their purchasing power parity values, but in the long run, the fundamental forces return the exchange rate to stable equilibrium.

Now, where do the costs and prices of individual products enter the equation? In a large diversified economy, such as that of the United States, the effect on exchange rates of a single product is minuscule. Through the aggregation of prices in the representative basket of goods, it has an effect, of course. On the other hand, through the exchange rate, the productivity improvement of our economy has an enormous effect on the prices of export products in foreign countries and on the prices of foreign goods in US markets. Thus, the productivity achievements of an individual company for a product are dwarfed by the productivity progress of the economy as a whole. This leads to the following statement: To compete effectively in a particular international market, we must be at least as productive in that field relative to our economy as our international competitor is relative to its economy. The managerial significance of this statement is that productivity improvement takes on an even more important role in corporate strategy.

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