Teaching Purchasing Power Parity

This is a simple post about how I have been teaching Purchasing Power Parity in ECON1000 for the last couple of years.

1. I ask the class for a student volunteer. The student has to come from a country I know next to nothing about, and that has its own currency.

2. I ask the student for the name of the currency used in his home country, and he answers (say) "shillings".

3. I then try to guess the exchange rate between the shilling and the Canadian dollar. I don't have a clue. Nor does anyone in the class, except the volunteer. (Any student who is from the same country, or has visited it recently etc., is not allowed to guess).

4. I then ask the volunteer to tell me the price of a dozen eggs (or a cup of coffee, or whatever) in his home country. He tells me.

5. I remind the students that a dozen eggs costs about $2.50 in Canada. We then all have a second attempt to guess the exchange rate. For example, if the student says that a dozen eggs costs 10 shillings back home, I guess that the exchange rate is 4 shillings to one dollar.

6. The student then tells us the exchange rate, and we see how close our second guess is.

It usually works quite well. Because:

1. About half the students figure out PPP by themselves, and can explain it to the other half.

2. They learn that a theory can be false, but still useful. Our second guess using PPP is never exactly right, but it's a lot better than our wild first guesses.

3. They learn the difference between a conditional forecast (the second guess) and an unconditional forecast (the first guess).

4. If our guess based on PPP is wrong (which it always will be, to some extent) I ask the student (rhetorically) why he doesn't buy eggs where they are cheap, load up his suitcase with eggs, and sell them where they are dear, whenever he flies between Canada and home. That teaches students both the equilibrating mechanism behind PPP, and the limitations of PPP in a world with transportation costs and other restrictions on trade.

(Last time I tried it, my second guess failed badly. But a couple of other students Googled the price of eggs in the home country, and said it was very close to PPP, and much lower than what the student said. Maybe he rarely bought eggs himself. Maybe I should try another good that students frequently buy. I could use the Big Mac Index, but I don't think that works as well pedagogically. After all, McDonalds is one company, and maybe they just choose to price that way.)

Comments

[Joel W]

Nick,

I think this will be very helpful if I ever teach 1st year macro again. I found teaching PPP quite difficult.

Eggs may not be the best example to use since the price in Canada would be set through supply management.

Thanks!

[JoeMac]

Nick,

It is my understanding that ppp occurs because of international arbitrage, right? Would that imply that the higher transaction costs are for arbitrage to occur, the less they will have equal ppp across nationalities? There will be less ppp for real estate and cars than eggs...

[Frances Woolley]

You could do the price of mobile phone plans. That would also give you something wildly off PPP because Canada has such expensive mobile rates, but people would know the prices.

I wonder if eggs in the shilling country are more comparable to Canada's factory farmed $2.50 eggs, or the $4.00 to $6.00 per dozen Rowe Farms free range/natural/organic/whatever eggs?

[Rob]

Judging by the prices of Big Macs listed in your link that index is not a good example of PPP, there is a 300+% difference between the cheapest and the most expensive in local currency units.

[genauer]

You have to avoid brand name / quality issues and go for lowest cost in the neighborhood for standard stuff,
where people are not brand sensistive, like:

Milk liter
Tomatoes kg
toast 500 g
Butter 250 g
Chicken, frozen piece
beer, simple liter
rice kg
flour kg
baguette (60 cm length)
ham, simple kg
coffee 500 g
noodles kg
pork kg
egg piece
cheese kg
mozarella kg
joghurt kg
no name Cola liter
O-Juice (100 %) liter
Sugar kg

less easy:

Vodka liter
schocolade kg
spices kg
cigarettes pack of 19
gasoline liter
electricity €/kWh

median income k$/a
monthly rent € / month / m 2

cleaning lady every 14d ca 3 hours
home price €/m2

any volunteers ? I ll have US and DE data from 2003 and 2010

[anon]

JoeMac, real estate is perhaps the most critical exception to PPP. The Balassa-Samuelson effect (which is a violation of PPP) is well explained by differences in land rent.

[Lord]

Some countries have high inflation rates so data currency could be an issue.

[genauer]

Lord,

that is the whole point of PPP, figure out, what the "real value" is, first in general, and then for your own consumption profile.

Answering a simple question, what is a salary of x Euro in Dresden (Germany) worth in y US Dollar in Silicon Valley, vs z loonies in Ottawa. Just going by the present day market exchange rate can be easily off by 40 %, or more.
( EURUSD=x varied between 0.83 and 1.6 during 2001 - 2008 )

general Inflation rate deltas you can correct out easily
http://www.slideshare.net/genauer/currencies

Trickier is if your consumption profile deviates a lot from the average, like : I dont need a car in Dresden, in the US you are not a human being without a car. That can make easily a huge cost difference and completely different sensitivity to gas prices : - ) For many things, like flour, milk, I dont give a damn about brand or other potential quality differences. But for Prosciutto di Parma or Mozarella, I had to buy the 4x more expensive stuff in the US.
These items are most likely completely irrelevant for all other people here.

If you just go for eggs (which are 10 Euro cents here around) or any other single item, you will be surprised how much that can vary for whatever reason, dairy stuff is permanently much cheaper in Germany

[Simon van Norden]

Macroeconomists always confuse PPP with the Law of One Price (LOOP). LOOP just refers to the fact that international arbitrage, as Nick pointed out, should be able to equalize prices. And he nicely points out that sometimes it will and sometimes it won't.

But PPP is about price *levels*; it's a statement about the relative cost of living in two countries. What most people teaching this forget is that LOOP doesn't imply PPP. Here's how I would explain this to students....

Think of a simple world with two countries: Japan and Argentina. This world has only two goods: beef and fish. The price of beef is the same the world over (LOOP holds), regardless of whether we look at the price in yen or pesos. The same is true for fish.

Now suppose beef prices rise relative to fish (due to mad cow disease or something.) Life in Argentina just become more expensive relative to that in Japan. Despite LOOP.

[Peter T]

Not a bad way of teaching. Does Nick go on to teach that prices are social? That price often (not always) reflects some social - not individual - consensus about what it 'ought" to be, and that persisting differences within and between societies defy arbitrage? Or is it just left at this, unmoored from empirical context?

[Nick Rowe]

Peter T: "Does Nick go on to teach that prices are social?"

No. I don't go on to teach that prices are social; I taught that in week 2. "Social" means "pertaining to the interactions of two or more people", and when I teach demand and supply I am (obviously) teaching how prices get determined by the interactions of the people who are buyers and sellers. Every teacher of economics teaches that prices are social (except maybe, just maybe, a few soi-disant 'political economists' who still teach the old cost-of-production/labour theories of price, where price, or 'value', is something inherent in the history of an object, rather than a relation between the people who buy and sell their rights in that object.

"Or is it just left at this, unmoored from empirical context?"
'...unmoored from empirical context...'??? Haven't I just been talking about the price of eggs, both in Canada and abroad, and exchange rates? Is that not empirical context? And empirically testing (in a very crude way of course) the extent to which data on the price of eggs helps us predict data (or at least, a datum) on exchange rates?

Geeeez. Was that a troll?

[Nick Rowe]

Simon: I confess I hadn't thought much about the relation between PPP and LOOP. Or maybe I did in the past, but had forgotten it. Let's see; defined in your way, LOOP plus same basket of goods in 2 countries implies PPP. Absolute PPP is undefined if the two baskets are different, because it makes no sense to ask whether the price of electricity is the same as the price of eggs unless we specify common units, which we can't. Relative PPP is still defined, and will be true iff relative prices don't change.

In slightly more advanced courses I prefer to teach PPP as a limiting case where the elasticity of demand for the Canadian-produced basket of goods (Net Exports) becomes perfectly elastic wrt the real exchange rate.

JoeMac "It is my understanding that ppp occurs because of international arbitrage, right? Would that imply that the higher transaction costs are for arbitrage to occur, the less they will have equal ppp across nationalities? There will be less ppp for real estate and cars than eggs..."

That's the way I think of it. However, even if there is only one good that can be traded across countries, if non-traded goods have a high enough cross-price elasticity of demand or supply with that one traded good, we could still get PPP for those non-traded goods.

All: Yep, maybe eggs aren't the best example for me to use. Especially since Canada has supply management of eggs. But on the other hand, maybe another country, taken at random, also has supply management of eggs? Plus, things like supply management are a fact of life, and I want to teach them both that PPP works and that PPP fails, because of things like supply management.

[Frances Woolley]

Nick: 'Yep, maybe eggs aren't the best example for me to use.'

It's as good as anything. Something that has interesting subtleties is much better from a teaching point of view than some abstract example that works out perfectly. I tend to use t-shirts and rice a lot, t-shirts because they're just so amazingly cheap (think about it) and have a complex but understandable production process (grow the cotton, harvest the cotton... etc), rice because it's a fairly culturally neutral basic commodity, more culturally neutral than bread or those cliched standards of econ textbooks: beer and pizza.

[genauer]

1. Supply management
2. eggs, or better alternatives
3. prices by supply or demand, or as a social construct

1. Supply management ? You mean: like "government price controls" ? Socialism ?

2. Eggs
Beyond "supply management", eeeewwh:
- eggs are not easily storeable,
- are therefore more prone to seasonal patterns (Eastern, Xmas)
- not easy to transport, (price in Cornell, US was August 2010 0.89 USD a dozen !)
- come in different sizes (S,M,L)
- different quality, as Frances mentioned

(A little real time egg anectode: sales quantities of eggs are limited in some stores here around, because
the European Union made some laws on minimum cage sizes for chicken, and only 15 years later actually enforces them now : - )
That means our Czech neighbors, hoping for another extension for this cost adder, can't sell their eggs right now,
and come over the border to buy german eggs in huge quantities : - )
The Price for chicken dropped by 15 %, maybe correlated, because the cost calculation doesnt work out without the eggs ?

I would be actually interested, if somebody could check down my short list of carefully selected items, above, when he/she goes to the grocery. This should not take more than 5 Minutes for taking the prices (I can do conversions by myself) and typing another 5 minutes. Suggestions are very welcome, what else to add to this list, canned tomatoes, champignons, peas, pizza (2 (0.35 kg) for 2.39 Euro here, but again, with ham, champs, etc on it) ??

I think what we will find out, is that the LOOP is not a good approximation, and dont use the word "law"

[genauer]

3. prices and wages

Nick, I dont think Peter T is a troll, he just describes not only his perception, but in fact his REALITY. For him, as much as for the large majority of people (at least in Germany, and I am pretty sure in Canada as well)supply and demand, price (incl. price of labor, a.k.a. as wages) setting by negotiation on a market, are purely theoretical concepts.
He is just a price taker, he gets and pays whatever came out in decisions of other people.
That there is ultimately supply and demand behind it, he and the majority have no chance to see.

When does the average person ever bargain over a price ? In a more than symbolic way ?

I realized this just a few years ago, when slightly more conservative, definitely not socialist people, I know, started talking about
price controls for gasoline.

What? Socialism, in my family? (She is the second wife of my father, not my genes : -)

I have to add, I can calculate the price of gasoline usually within 1 % / 1c just by looking up on Bloomberg the price for Brent (US would be WTI, Cushing)the Euro / Dollar exchange rate. This is a very transparent, competitive market. It is extremely boring in this way.

It does not help to demonstrate these people such fundamentally simple calculations, simple algebra. Gasoline companies are evil, and have to be controlled. Even the "liberal" (in a european way of meaning, free market and trade) party falls in line, aaargh.

Even in my Fatherland Germany. This is the reality. As much as I do not like it.

[Simon van Norden]

genauer: Law is the right word for LOOP - but we KNOW it is often violated. You see these examples yourself everyday. The price you pay for bottle of water (for example) is very different depending on whether you buy it from a vending machine, in a sports stadium, in a cafeteria, in a grocery store, etc. Even in a single store, its price may vary depending on whether we buy one, six, or 24. You no doubt are aware that some gas stations tend to have higher prices and some lower. But those are markets where we might expect LOOP to work. In other markets, arbitrage may be limited because goods are less perfect substitutes (haircuts or housing, for example) or because arbitrage is expressly forbidden (airline tickets.)

[Tom]

I think the Big Mac is probably better than "just eggs", without specifying quality, etc -- because McD's already does the quality spec, with maximum efficient local sourcing. I suspect it is the "best" single product for over all OECD countries, and over 100 UN countries. (Kurdistan not yet a country.)

In Rwanda, chicken per kilo was more expensive than beef; very surprising.

A liter of the "most popular" local beer would be my bet as the best single local product for PPP; is Budweiser the most popular in the US? (2* 1/2 liter to 2*1/2 quart is a small conversion issue).

[Tom]

Here's a fine BBC "What are you on the Global Pay Scale" using PPP:
http://www.bbc.co.uk/news/magazine-17543356

Funny that one of the biggest jumps is from Slovakia to Poland -- and it's true that many Slovaks go across the borders to buy in Poland; as well as in Austria. I don't quite understand how prices can be cheaper in much richer Austria (Vienna) than in Slovakia (Bratislava), with these two capitals being the nearest capital neighbors in Europe.
Yet it's the case.

Still, my Slovak wife and I seldom bother to try to get the 5-10% discount available by going 60 km in.

I'd guess the low Euro cost in Austria is why they are ranked so high; Norway's oil and Luxumbourg's special "off-shore" status explain the other two ahead of the US.

[Anuj]

going to try this today with my macro class - we're beginning to discuss exchange rates today. Thanks for the tip!

[Nick Rowe]

Anuj: Let us know how it goes.

[PPS]

I would offer to compare prices for a basic men's haircut. It seems a pretty uniform measure around the world.

[Ruben]

My country wouldnt work that well: Cuba

[Alex Plante]

Maybe you should educate Andrew Coyne about PPP. He doesn't seem to understand that having an exchange rate 20% above PPP and running a 2% of GDP current-account deficit is not healthy for our manufacturing base, nor for our debt situation. We're accumulating foreign debt while undermining our ability to pay off that debt.