International Price Comparisons Based on Purchasing Power Parity
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Purchasing Power Parity International price comparisons based on purchasing power parity Because exchange rate movements, in general, tend to be more volatile than changes in national price levels, the purchasing power parity approach provides the proper basis for comparing living standards and examining productivity levels over time Michelle A. Vachris magine you are planning a trip to France and using exchange rates to convert them into a and and would like to figure out how much cur- single currency would not yield an accurate com- James Thomas I rency you will need during your visit. You parison. Again, the comparison based on ex- would need to know how much in French francs change rates does not take into account differ- it would cost for incidentals such as meals, ing prices among the countries. sightseeing, and souvenirs. What information In each of these scenarios, analysts could con- would be helpful to you in making your estimate? struct better estimates if they convert the data You could check the price of, say, a lunch in your into a common currency and value it at the same hometown and then convert that figure into francs price levels. In September 1998, the Organisa- using the exchange rate. This type of estimate tion for Economic Co-operation and Develop- would not be very accurate, however, because it ment (OECD) released price level data and mea- is likely that a lunch in your hometown costs rela- sures for 1996 as a part of the Eurostat-OECD tively more or less than a lunch in France. A bet- purchasing power parity (PPP) program. ter estimate would be based on the price of a lunch (Eurostat is the statistical office of the European in France. Union.) The purpose of this program is to com- Similarly, if you were opening a subsidiary pare economic data across countries without company in Japan, how would you determine the using exchange rates. As illustrated in the pre- salaries for your employees? Again, using the ex- vious scenarios, exchange rates do not neces- change rate to convert the salary you would pay sarily reflect the relative purchasing powers of in the United States into yen would not be accu- the different currencies and applying them can Michelle A. Vachris rate. To adequately compensate employees mov- produce inaccurate comparisons. To accurately is an associate professor ing overseas, you would need information about compare GDP data across countries, one must ex- of economics at Christopher Newport the cost of living in Japan. press the data in a common currency and value University and Finally, if a government or international orga- it at the same price level. These problems are James Thomas is a senior economist nization were comparing national expenditures similar to those encountered in comparisons of in the Office of Prices across different countries, merely collecting the GDP across time for one country. Of course in and Living Conditions, Bureau of Labor Statistics. gross domestic products (GDPs) of the countries the case of comparison across time, the data are Monthly Labor Review October 1999 3 Purchasing Power Parity already expressed in one national currency, but the figures must ket of goods and services with the expenditure patterns in the accommodate changes in the price level for the comparisons country determining the items selected. Likewise, to calculate to have any meaning. Purchasing power parities are estimates PPPs, one needs to price a representative basket of goods and derived from the relative price levels in different countries and services across countries. In the interspatial case, however, this reflect the rate at which currencies can be converted to pur- becomes difficult to implement, as the different countries can chase equivalent goods and services. Therefore, a PPP is the have very different expenditure patterns. The availability of rate of currency conversion that equalizes purchasing power common representative products is dependent on the number of different currencies and so has the dimensions of an ex- of countries, the extent to which their markets and expenditure change rate as well as a price index. PPPs are preferable to patterns are similar, and the type of specification used to de- exchange rates for converting national expenditure data into a fine selected products. Even between economies as similar as common currency because they also adjust for differences in the United States and Canada, there remain important differ- price levels and reflect only differences in the volume of goods ences in expenditure patterns due to differences in climate, and services purchased between countries. tastes, packaging, regulations, and the like. Therefore, the ini- International organizations involved with multilateral com- tial groundwork for calculating PPPs is to determine a list of parisons of real GDP and its components increasingly base such goods and services and their detailed specifications for pric- comparisons on PPPs.1 The European Commission also uses ing by each country. The final lists for the 1996 comparison PPPs to determine funding levels, as well as to adjust staff sala- contained both traded and nontraded goods and services that ries. Moreover, two recent reports analyzed the strengths and covered around 4,000 items, including about 2,900 consumer weaknesses of the PPP programs.2 Independently, both came goods and services; 800 pharmaceuticals; 186 capital goods; to the same conclusion, reaffirming the importance of using 50 motor vehicles; 34 government, education, and health ser- PPPs for real multilateral comparisons of GDP and related ag- vices; and 20 construction projects. gregates. The second component needed to calculate purchasing Historically, the first comprehensive investigation of the power parities is the expenditure patterns for the participating relative value of money in different countries was published in countries. These figures, expressed in national currencies, are 1940 by Colin Clark. This study compared the purchasing derived from the national accounting data for each country. power of many currencies across a range of consumption goods. The classification system that provides the framework for the In the early 1950s, Irving Kravis and Milton Gilbert, at the calculations is the 1968 System of National Accounts and the Organization of the European Economic Community (prede- 1979 European System of Economic Accounts. The defini- cessor to the OECD), used national accounts data to compare tion of expenditure starts at the basic heading level, which in- national incomes of four western European countries and the cludes a group of similar commodities that are representative United States. The methodology they developed was further of the purchases made in participating countries for which a refined in benchmark studies for 1970, 1973, and 1975.3 In sample of detailed item specifications can be determined. the early 1980s, the Eurostat-OECD PPP program was later es- Eurostat had 270 basic headings, while the OECD had 218. The tablished independently, with its own methodology, timetable, difference between the two headings was attributed to the cat- and mission to compare national incomes and price levels for egory, household final consumption expenditures; otherwise, the European Union and OECD member countries. Benchmark the breakdowns were the same. studies were published under this program for 1980, 1985, Once the detailed specifications of goods and services have 1990, and 1993. been defined within the expenditure categories, each partici- This article analyzes the 1996 Eurostat-OECD purchasing pating country provides national average prices for as many of power parities study, which covers 32 countries, including all the items as possible. Possibly, the most important issue in of the current 29 member countries of the OECD, except one price selection is choosing identical products that are also im- (Korea), plus four additional countries (Israel, Russian Fed- portant in terms of expenditure patterns. These prices, ex- eration, Slovak Republic and Slovenia). pressed in national currencies, are for the most part, transac- tion prices, although in some cases, list prices are used as a Methodology proxy. Many of the countries perform special pricing surveys to meet the requirements of the program; however, the United Purchasing power parities measure relative price level differ- States primarily provides prices calculated from data already ences for one time period across countries. In that respect, collected by the Consumer Price Index (CPI) and Producer Price PPPs can be thought of as interspatial price indexes, and the Index (PPI) programs. The Bureau of Labor Statistics does not methodology and data requirements belong to the methodol- do any special sampling for the OECD item specifications and, ogy of index number theory. For example, to calculate as a result, the average prices provided are not the same as the intertemporal price indexes used to measure price change for average price series produced by the CPI. Where possible, BLS one country over time, one needs to price a representative bas- adjusts the underlying data from the CPI average price series to 4 Monthly Labor Review October 1999 match the OECD questionnaire specifications. If insufficient Table 1. Purchasing power parities, exchange rates, average price data exist to estimate OECD specifications, then and price level indexes, 1996 list prices are used in lieu of, or to supplement average price (National currency per U.S. dollar) data when necessary. In particular, all of the OECD transporta- Purchasing Price Country power Exchange level tion survey, most of the clothing survey, and some of the con- parity rate indexes sumer durables and furniture surveys contain list prices for the United States. In addition, by using regression methods and United States ......................... 1 1 91 CPI rent data collected for the , the United States is able to esti- OECD 1....................................... 1.1 1 100 mate prices for the rent specifications priced by the other par- Australia ................................ 1.3 1.278 92 Canada .................................. 1.19 1.363 79 ticipating countries.