Purchasing-Power Parity: Definition, Measurement, and Interpretation

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Purchasing-Power Parity: Definition, Measurement, and Interpretation

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Robert Lafrance (Bank of Canada)
Lawrence Schembri (Bank of Canada)

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Lawrence Schembri

Abstract

This article examines the concept of purchasing-power parity (PPP) and its implications for the equilibrium value of the Canadian exchange rate. PPP has two main applications, as a theory of exchange rate determination and as a means to compare living standards across countries. Concerning exchange rate determination, PPP is mainly useful as a reminder that monetary policy has no long-run impact on the real exchange rate, since the exchange rate can deviate persistently from its PPP value in response to real shocks. To compare living standards across countries, PPP exchange rates constructed by comparing the prices of national consumption baskets are used to translate per capita national incomes into a common currency. These rates are useful because they offset differences in national price levels to obtain comparable measures of purchasing power, but they are not an accurate measure of the equilibrium value of the exchange rate. The authors conclude that the current deviation of the Canadian exchange rate from the PPP rate does not imply that the exchange rate is undervalued, but that this deviation reflects the impact of persistent real factors, in particular, lower commodity prices.

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Article provided by Bank of Canada in its journal Bank of Canada Review.

Volume (Year): 2002 (2002)
Issue (Month): Autumn ()
Pages: 27-33
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Handle: RePEc:bca:bcarev:v:2002:y:2002:i:autumn:p:27-33

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Christopher Ragan, 2005. "The Exchange Rate and Canadian Inflation Targeting," Working Papers 05-34, Bank of Canada. [Downloadable!]
Other versions:
- Christopher Ragan, 2005. "The Exchange Rate and Canadian Inflation Targeting," Bank of Canada Review, Bank of Canada, vol. 2005(Autumn), pages 41-50. [Downloadable!]

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