Purchasing Power Parity (PPP) is an extension of Adam Smith's concept of "market equilibrium." It is a theory that the value of a currency should be determined by market forces, not governments or other interest groups. "Parity" in this theory is another word for equilibrium, or the "equality" of value relative to goods that can be bought.
Instructions
1. Use the example of two countries. Using more would be confusing. Talk about goods moving between China or Japan. If there are no impediments to trade, the value of a movable good in Japan would be identical to that of China, if measured in a single currency. PPP is purely theoretical, since there are always barriers to trade, transportation costs and other sources of trade friction.
2. Lay out the concept of market equilibrium relative to the two countries being analyzed. Assuming no sources of trade friction, there would be no rational reason to have a good made in Japan worth more in China using the Japanese currency, the Yen. The good might cost more in China relative to Chinese incomes, but that would just suggest that the standard of living in the two countries is different -- not that the value of the good is the same. PPP treats different standards of living as "trade friction" or distortions in trade.
3. Use a clear and simple example. Presume Japan wants to sell one television in China. Next, assume that 1 Japanese yen is worth 2 yuan. In the PPP theory, the television, if it is worth 10 yen in Japan, must then be worth 20 yuan in China. The fact that 10 Yen in China might be the worth of an entire month's salary in China does not matter, as far as PPP is concerned. But this is rarely the case due to manipulations of currency, political pressure on the money supply, bank policy, trade barriers and other sources of price distortion. Use this example throughout the discussion, since PPP can be very abstract.
4. Describe a realistic situation, in which it is entirely possible that the 10-yen television might be worth 30 Yuan in China. Removing all other sources of trade distortion, the reason is that the Chinese yuan is overvalued. Therefore, Chinese exports will increase since they are worth less in Japan. The concept is used to determine -- once all other variables have been accounted for -- how manipulative bank policies can either hurt or help trade relative to currency values.
5. Connect all the above concepts together in explaining the concept of exchange rate values. For example, 1 yen from Japan is supposed to be worth 1 yen in China. This is never the case, but PPP is a theoretical measure to describe trade distortion. If 1 yen in Japan is worth 2 yen in China, this can only mean---all other variables being equal---that the yuan is overvalued and hence distorts the yen value in China. This then distorts Chinese prices relative to their exports, since the 2 yen Chinese good is worth 1 yen in Japan. If this is the case, then the Japanese would gobble up Chinese exports since they would sell for half of the Japanese-made good.
