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Imagine a person based in India is working for a client in the USA. The client pays the person 100 USD. The currency is converted into INR, which turns out to be 100 * 74 = 7400 INR.

But if we convert the currency according to Purchasing Power Parity rate, then it should have been 100 * 21.21 = 2121 INR.

So, the USA man is spending money which could have bought him 2121 INR worth of goods and services, but the Indian man is receiving money which can buy him 7400 INR worth of goods and services. So does that mean that 7400 - 2121 = 5279 INR worth of purchasing power is created out of thin air?

Snehanshu Phukon
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  • let's make it 2000 and 6000 for easy numbers. This means if a USA man moved to India he could have 3 times as much stuff. What that tells us is that India is such a bad place to be, that people aren't willing to move there even if they can have 3 times as much stuff. (note wages are also higher in the USA) – user253751 Nov 23 '20 at 15:09
  • @user253751 So what is the takeaway? – Snehanshu Phukon Nov 28 '20 at 07:52

2 Answers2

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No purchasing power is not created from thin air. When you convert money through PPP (expressed usually in terms of local currency to USD) you are getting information about what is the purchasing power of US dollar that would get you the same basket of goods under the law of one price. This is not the same as making currency conversion with exchange rate which generally tells you not much about what would be the actual purchasing power of different currency.

Moreover, it is generally agreed by international trade economists that one of the major reasons why you will find discrepancies between exchange rate and purchasing power parity is the Balassa-Samuelson effect (See Krugman et al. International Trade Theory and Policy). This is because according to Balassa-Samuelson theory the price level in a country depends on productivity mainly in the tradable sector (mostly consisting of goods) because tradable and non-tradable sector (mostly consisting of services) compete for the same workers. This in turn means that if productivity in tradable sector increases it will increase wages not just in tradable sector but also in non-tradable sector.

This is the reason why hairdresser with exactly the same level of skill will get much higher wage in US than in India. However, this in turn leads to violation of law of one price as then also prices in non-tradable sector will be generally higher in US (e.g. haircut in US will be much more expensive than haircut in India).

Beside Balassa-Samuelsson effect, divergence between PPP and market exchange rate can be also due to transaction costs (which lead to failure of one price), differentiated goods (beef produced under strict EU health regulations is not the same beef as beef produced in some developing economy), fixed investment costs that can also lead to deviations of law of one price and various composition issues when constructing price indecies (see Marrewijk International Economics: theory application and policy 2nd ed pp 471).

As a consequence of this there you will observe divergence between PPP and market exchange rate, but that is not the same as saying that some purchasing power was created out of nothing as they measure different things.

1muflon1
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  • Then why does one earn more while working for clients based in wealthy countries than by working for clients in less wealthy countries? And also vice-versa for the client, he pays less for services from less wealthy countries than from wealthy countries. – Snehanshu Phukon Nov 23 '20 at 11:24
  • @SnehanshuPhukon because of the above mentioned Balassa-Samuelson effect. “Wealthy” countries are usually more productive than “poor” countries in production of tradables. If one country is more productive than another even if only in a subset of goods it’s wages will be higher even in industries where productivity is exactly the same – 1muflon1 Nov 23 '20 at 11:36
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A very interesting way to put this. But, I think, you are forgetting the cost incurred by the Indian guy.

By buying the service from India in 100 USD, the US man is letting go of goods/services worth 100 USD in USA. So this service/product must be giving him the utility worth that much.

On the other hand, the Indian is charging 100 USD as that must the disutility from working and/or cost of product. Clearly, for the Indian the value his work is not 2121 INR but 7400 INR (otherwise he would have charged less).

Interestingly, had the US man visited India and then asked for this service, he would have found it very expensive, as it would have meant letting go of much more goods and services in India than he does in US.

Dayne
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  • Actually I was not trying to address the issue relating to PPP and exchange rate discrepancy. I was trying to reason that the difference should not be interpreted as gain as the valuation is different in different countries. Balassa-Samuelson effect offers one explanation to difference in valuation of course. – Dayne Nov 22 '20 at 11:40
  • upon later reflection I figured you probably addressed question in title without addressing question in the body so I deleted my comment, but still the explanation for differences between PPP and market exchange rate here would generally not be considered to be major explanation of these differences – 1muflon1 Nov 22 '20 at 11:41
  • @Dayne The Indian guy would have charged 2121 INR if the client was Indian. And the US guy would have probably paid 500 USD if he bought the service from an American. – Snehanshu Phukon Nov 23 '20 at 09:58
  • Why do you think so? If there is competition someone else would offer the service to US person at 2121/74 USD. – Dayne Nov 23 '20 at 10:00
  • That's a different scenario, in my question, I have clearly mentioned the premise. – Snehanshu Phukon Nov 23 '20 at 11:22
  • Premise is incomplete. You have to give logic of your comment that why the indian would charge 2121 INR to indian client and so high to US client. – Dayne Nov 23 '20 at 11:24
  • Because for an Indian, $100 can be a huge amount, whereas for the American it is quite affordable. – Snehanshu Phukon Nov 28 '20 at 07:51
  • By that logic Indian's should not sell anything in India but rather export everything, because outsiders can pay more than Indians. – Dayne Nov 28 '20 at 08:21