Although the United States has for years argued that China deliberately maintains an exchange rate that undervalues the yuan relative to the dollar to help China's export industries, in May 2015 the IMF announced that the yuan was no longer undervalued. To discuss undervaluation, you obviously need a benchmark that provides the correct value of a currency. One popular benchmark model is purchasing power parity (PPP). PPP links exchange rates to the prices of goods in different countries, and this chapter explores these relations in depth.
Why should you study the theory of purchasing power parity? First, PPP provides a baseline forecast of future exchange rates that is usually considered whenever it is necessary to forecast future cash flows in different currencies, especially when inflation rates differ across these countries. Consequently, PPP plays a fundamental role in corporate decision making, such as the international location of manufacturing plants, and other international capital budgeting issues. Second, understanding the theory of purchasing power parity is important because deviations from PPP significantly affect the profitability of firms. For example, pricing products internationally, analyzing long-term international contracts, hedging the cash flows of an ongoing international operation, and evaluating the performance of foreign subsidiaries all require an analysis in terms of deviations from PPP. Third, PPP is particularly useful in assessing cost-of-living differences across countries. If you are going to work in a different country, and your salary is denominated in a foreign currency, you would like to know what standard of living you will experience.
As we will see when we look at the data, PPP does not hold very well in the short run. The deviations from the theory are sometimes so large that some economists dismiss the theory, at least as far as the determination of exchange rates is concerned. Nevertheless, for the world's major currencies, we will also see that PPP has some validity in the long run. It even works reasonably well over shorter horizons, whenever inflation dominates the economic environment.
Because purchasing power parity involves comparing the purchasing power of a money within a country to the purchasing power of that money when spent in a different country, we need to examine how to measure these purchasing powers. When economists convert from monetary magnitudes into units of purchasing power, they say they are converting from nominal units into real units.