The previous chapter demonstrated that the distinction between tradables and nontradables becomes important in a variety of circumstances that often prevail in LDCs. The empirical investigation of purchasing power parities in this chapter will reveal the regularities that exist between relative prices of tradables and nontradables in the process of development. The empirical links between the real and nominal exchange rates will also be investigated.

Purchasing power parity and exchange rates

The measurement of purchasing power parity (PPP) was designed to lead to comparisons of real incomes across countries. Such comparisons, however, are based on price level comparisons. Prices have multiple uses, among others as guides for the allocation of resources and as markers of efficiency. Should inappropriate prices arise, Pareto losses can be related to the violation of the restrictions of the fundamental theorems of welfare economics.

Suppose that certain price index calculations revealed that the price level at region X is 50% higher than at region Y. A new price emerges, the “bridge price,” which is the ratio of price in Y to price in X, or 0.66. This is the number by which one multiplies a given national income in X to give it the same purchasing power as a corresponding income in Y. Such “bridge prices” are often fairly uninteresting when they are used merely as income-ranking devices. In certain cases, however, they cease being simply “bridges” and assume a role in allocating resources. Any bias that exists in defining and constructing such prices would carry over to the allocation process as well.