ABSTRACT

The purchasing power of a consumer depends upon wealth and the prices of the goods and services. The customer can purchase domestically or from aboard. The domestic purchasing power is mainly affected by the inflation rate of individual countries, and it is relatively equitable across mature economies. The international purchasing power is more volatile and is affected by both exchange rate and prices. A consumers buying power is also influenced by the changes in wages relative to inflation. Analysis of current exchange rates, prices and wages leads to the belief that foreign shoppers can get better bargains in Japan and the US at the present time. Consumers in emerging economies especially China and Russia have experienced significant improvement in purchasing power recently. They may catch up with the living standard of rich countries in the future if this growth rate sustains.

Acknowledgements
I would like to thanks madam Iram for teaching the basic concepts of Development Economics, and My Mother for the helpful discussions on the subject, and my Brother for proof reading the manuscript.

Topic: Impact of Inflation on purchasing power Objectives:

Learn How we can measure inflation and purchasing power Knowing about purchasing power parity Tackle Inflation Affect of inflation on purchasing power

Content: Phase I
Acknowledgements Abstract Introduction

Phase II
Review of Literature

Phase III
Research Methodology

Phase IV
Conclusion References

Introduction of purchasing power

How Does Inflation Affect the Purchasing Power of Money?
Inflation and Purchasing Products Inflation and Debt Deflation and Purchasing Products Deflation and Debt

What is Inflation? Measures of inflation are

Producer Price Indices Commodity price indices GDP deflator Regional inflation Aspect price inflation Issue in measuring 7 most harmful effects of inflation

Review of literature
Consumer price indexes of representative economies from 2000 to 2008 Relative purchasing power parity of representative economies from 2000 to 2008 PPP exchange rate published by the International Monetary Fund (IMF, ref. 2) Changes of nominal exchange rate from 2000 to 2008 Changes of real (CPI) exchange rate from 2000 to 2008 Increase in different countries from 2000 to 2008 (source: ref. 1, 3 to 14) Relative purchasing power parity from 2000 to 2008 after adjusting for wage Real exchange rate from 2000 to 2008 after adjusting for wage increase Market exchange rate from 2000 to 2008 Weekly Wages from 2000 to 2008

Research Methodology
What is purchasing power parity? Use of purchasing power parity

Conclusion or Summery References

INTRODUCTION
The purchasing power of a consumer depends upon wealth and the prices of the goods and services. The customer can purchase domestically or from aboard if there is a free trade condition. If the purchase occurs in the international market, exchange rate will play a role in calculating affordability. Furthermore, a consumer who is employed earns income while spending. His/her buying power also depends on the changes in wages relative to inflation. This article discusses the factors such as exchange rate, prices and wage level affecting the purchasing power of consumers who reside in various countries in the world from 2000 to 2008. Inflation can be felt at gas pumps and grocery stores. The official government consumer price inflation rate was 2.7 percent higher as of March, compared to one year ago. It had been zero for all of 2009 and 1.6 percent for all of 2010, which was the reason provided as to why social security checks did not require a cost-of-living-adjustment this year. However, consumer price inflation is building and could easily rise to 4 to 5 percent by the years end, and possibly even higher if there is no retreat in gas and food prices. Producer price inflation is already near 6 percent. Incredibly, however, U.S. government bond yields are implying low future inflation. The U.S. Treasury can borrow today at a low 3.4 percent rate for 10 years, despite the very high budget deficit and plenty of money printing. Savers lose if there is unexpected inflation because of the loss in purchasing power of the money saved. Conversely, borrowers win from unexpected inflation. How does this work? The table below shows past returns for people who saved money with a 10-year U.S. Treasury. For example, someone who saved $100 via U.S. Treasury in 1950 would have accumulated $121 in at the end of the 10-year term assuming all annual interest payments have been saved. However, there was some inflation over that decade so their purchasing power was eroded to the point that the original $100 investment would have provided only $102 in purchasing power after 10 years. Other periods are shown below. People who saved money at the start of 1970 actually came out with much less purchasing power after 10 years.

What about going forward over the next 10 years? If you invest $100 in the 10-year U.S. Treasury bond today, you will have $131 in ten years based on todays 3.4 percent yield. It is unlikely that we will experience the same kind of inflation seen in the 1970s. However, if such a high rate of inflation were to occur, then the $131 cumulative savings after 10 years would translate into only $64 in purchasing power. On the other hand, if there is low inflation like in the 1950s, then the saver would have $104 in purchasing power

Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold or silver, or fiat currency, or free-floating market-valued currency like US dollars. As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency. If one's monetary income stays the same, but the price level increases, the purchasing power of that income falls. Inflation does not always imply falling purchasing power of one's money income since it may rise faster than the price level. A higher real income means a higher purchasing power since real income refers to the income adjusted for inflation. For a price index, its value in the base year is usually normalized to a value of 100. The purchasing power of a unit of currency, say a dollar, in a given year, expressed in dollars of the base year, is 100/P, where P is the price index in that year. So, by definition the purchasing power of a dollar decreases as the price level rises. The purchasing power in today's money of an amount C of money, t years into the future, can be computed with the formula for the present value:

Where in this case i is an assumed future annual inflation rate

How Does Inflation Affect The Purchasing Power of Money?

Inflation affects how people can spend money. Inflation is an economic phenomenon that has an increasing change in the price of goods and services. A closely linked phenomenon to inflation is deflation, sometimes called negative inflation. Deflation occurs when there is a decreasing change in the price of goods and services. Inflation and deflation affect how a consumer can buy goods and the value of debt. Inflation can occur in wages or prices.

Measuring Inflation
Price inflation is typically measured using the consumer price index (CPI). The United States Bureau of Labor Statistics keeps track of the CPI. The CPI takes a constant basket of goods and sees how the price changes from year to year. If the price of the basket of goods increases, then there is price inflation. If the price of the basket of goods decreases, then there is deflation. People measure wage inflation using the employment cost index. The employment cost index shows how the cost of labor increases or decreases over a period of time.

Inflation and Purchasing Products

Price inflation decreases people's ability to pay for goods. The concept at a basic level says if an employee's wages remain steady, but the cost of goods increases, then the employee can afford fewer goods. As wage inflation occurs, people will be able to buy more products. A general misconception is that when wages rise, prices also rise and according to the Federal Reserve Bank of Cleveland, there is little support that wage inflations cause price inflation.

Inflation and Debt

Price inflation is a debtor's best friend and a creditor's worst enemy. As the prices increase, the amount borrowed will deteriorate in value so the debtor is paying back less money and the creditor is receiving less money. For example, a student borrows $100,000 in 2005, and then inflation occurs over the next couple years. Inflation then makes that $100,000 comparatively worth only $80,000 due to the increase in prices. When wages inflate, both the borrowers and the creditors win. The borrowers can repay their loans quicker due to higher income. The borrowers then should receive loan payments quicker if the borrowers pay back their loans with the increased wages.

Deflation and Purchasing Products

Deflation has the opposite affect of inflation, in that consumers will be able to buy more products as the price for the product decreases. Deflation, however, is not good for the overall economy and can be worse than inflation. If a company has costs sunk into production before deflation, these costs will not readjust to the deflation. Since the costs remain high to the price of money, the company will receive less revenue when the product sells at a deflated price. As wages deflate, consumers can buy less with their money because their disposable income is decreased.

Deflation and Debt

Deflation and debt has the opposite affect as inflation. Debtors will pay back more money than they comparatively took out and creditors will receive more money. As wages deflate, people may have a harder time paying off debt, which will increase the number of defaults by borrowers.

INFLATION
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

Measures of inflation are

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index.] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007. Other widely used price indices for calculating price inflation include the following:

Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index. Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee. Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other common measures of inflation are: GDP deflator is a measure of the price of all the goods and services included in gross domestic product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure. Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US. Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widely accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices

Issues in measuring
Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price. While comparing inflation measures for various periods one has to take into consideration the Base effect (inflation) as well. Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace. Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. When looking at inflation, economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy. Most inflation indices are calculated from weighted

averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median value. 7 most harmful effects of Inflation on different aspects of a developing country like India

Why should we be concerned with the problem of inflation? The answer lies in two facts: I. Left to itself, inflation would move from its initial beneficiary stage to that of a harmful one. For this reason, it is necessary to prevent inflation from gaining strength, II. A stronger inflation is more difficult to control than a mild one. And there is no way to control a hyperinflation. The beneficial effects of inflation are limited to only its initial phase when the price rise is sufficiently mild. During that period, there is a favorable impact upon both output and employment. The increase in prices and distributive inequalities are more than counterbalanced by gains in output and employment. However, once inflationary process gathers some strength, its ill effects come to dominate the scene. These have been discussed above and would be only briefly enumerated here. 1. Right from the beginning, inflation adds to inequalities of income and wealth. However, in its last phase, it is not longer able to do so because money ceases to bean acceptable store of value. It is a generally agreed statement that inequalities reduce aggregate social welfare and should be avoided provided, in the process, production activity does not suffer. 2. Every economy needs a continuous addition to its productive capacity for which it should encourage capital formation. In a money economy, capital formation takes place when a part of money income is saved and transferred to the investors who, in turn, use it for investment and capital formation. However, inflation, by its very nature, discourages saving activity. It makes consumption more attractive than saving. The adverse impact on saving and capital formation is more serious for-an underdeveloped country because it needs a higher rate of capital accumulation. 3. Inflation leads to a shift in the asset preference of wealth holders. Their preference for tangible assets may be counterbalanced, in the initial phases of inflation, by an increase in interest rate. However, in later stages of inflation, even an upward movement in interest rate fails to neutralize the shift in asset preference.

4. Inflation leads to balance of payments problems. When domestic prices rise faster than prices in foreign countries, exports tend to lag behind imports. The, rate of exchange also tends to depreciate both on account of falling purchasing power of currency within the country and adverse balance of payments. In some cases, there may also be an outflow of capital. A developed country may be able to handle the problem of adverse balance of payments through structural adjustment, but a developing country is not able to do so easily because they suffer from large institutional and other rigidities. 5. Inflation distorts the financial system of the country. In its initial stages, the system is able to withstand its adverse effect because the financial institutions by their very nature tend to ignore the purchasing power of money and operate with reference to interest rates and maturity of financial instruments. However, when inflation gathers strength, the financial system cannot withstand it and collapses. 6. Once inflation crosses its earlier phases, strain on the financial system, speculation, expectations of further price rise and similar other forces lead to an increase in unemployment and a fall in output. Eventually, in the final phase of inflation, the output and employment levels fall to abysmally low levels. 7. First Inflation is a hidden tax as it leads to fall in purchasing power of money. It happens particularly when authorities resort to deficit spending when their tax receipts lag behind and their expenditure does not decrease. The taxpayers therefore lose on account of reduced purchasing power of their money incomes. In other words, the authorities are able to collect resources from the taxpayers without specifically levying additional taxes on them. Secondly, when prices rise, the fixed income earners find that the purchasing power of their money incomes is falling while the real income of the profit earners is increasing. When inflation becomes still stronger, the holders of financial wealth also lose. This way, inflation is a hidden tax by entrepreneurs on consumers and on recipients of contractual incomes.

Review of Literature
Figure 1: Consumer price indexes of representative economies from 2000 to 2008 (source: ref. 3 to16)

650

550

CPI United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa Saudi Arabia

2000 174.0 93.7 90.8 100.0

2001 176.7 94.7 92.6 107.7

2002 180.9 96.3 94.8 120.2

2003 184.3 97.3 96.6 129.5

2004 190.3 98.7 98.9 137.1

2005 196.8 100.8 101.1 142.8

2006 201.8 103.6 103.1 145.9

2007 210.0 105.7 106.2 150.4

2008 (May) 216.6 NA 108.2 156.0

102.2
441.0 100.4 97.0 131.3 93.2 100.0 100.0 98.9

101.5
458.0 101.1 97.7 135.4 97.4 121.4 105.7 97.8

100.6
477.0 100.3 101.5 139.5 102.9 140.6 115.4 98.0

100.3
496.0 101.5 103.6 142.8 107.0 159.8 122.1 98.6

100.3
514.0 105.5 105.8 146.5 112.6 177.3 123.8 98.9

100.0
536.0 107.4 108.0 150.6 116.3 199.7 128.0 99.6

100.3
563.0 109.0 109.8 155.5 121.0 219.0 134.0 101.8

100.3
600.0 116.7 112.4 160.1 125.6 238.8 143.5 106.0

101.7
636.0 NA 113.9 162.2 128.1 270.9 151.5 115.0

Figure 2: Relative purchasing power parity of representative economies from 2000 to 2008

2.3

2.1

Rel. PPP exchange United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa Saudi Arabia

2000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000

2001 1.000 0.995 1.005 1.060 0.978 1.023 0.992 0.992 1.015 1.028 1.195 1.041 0.974

2002 1.000 0.989 1.004 1.156 0.947 1.040 0.961 1.006 1.022 1.061 1.352 1.110 0.953

2003 1.000 0.980 1.005 1.223 0.927 1.062 0.954 1.008 1.027 1.083 1.509 1.153 0.941

2004 1.000 0.963 0.996 1.254 0.897 1.066 0.960 0.997 1.020 1.104 1.621 1.132 0.914

2005 1.000 0.951 0.985 1.262 0.865 1.075 0.945 0.984 1.014 1.103 1.766 1.132 0.890

2006 1.000 0.953 0.979 1.258 0.846 1.101 0.936 0.976 1.021 1.119 1.888 1.155 0.888

2007 1.000 0.935 0.969 1.246 0.813 1.127 0.963 0.960 1.010 1.116 1.978 1.189 0.888

2008 1.000 NA 0.958 1.253 0.799 1.158 NA 0.943 0.992 1.104 2.176 1.217 0.934

Figure 3: PPP exchange rate published by the International Monetary Fund (IMF, ref. 2)

18

16
Note*: x100 for Japanese currency.
Country United States United Kingdom Germany Brazil Japan* India China Canada Australia Mexico Russia South Africa Saudi Arabia 2000 1.000 0.645 0.934 0.867 1.498 8.473 1.828 1.218 1.362 6.195 6.833 2.110 2.678 2001 1.000 0.645 0.923 0.909 1.448 8.570 1.822 1.203 1.380 6.411 7.773 2.219 2.526 2002 1.000 0.654 0.919 0.985 1.407 8.630 1.801 1.193 1.393 6.737 8.833 2.413 2.554 2003 1.000 0.662 0.912 1.111 1.364 8.803 1.813 1.207 1.406 7.171 9.870 2.476 2.649 2004 1.000 0.663 0.893 1.172 1.310 9.006 1.891 1.215 1.421 7.501 11.507 2.569 2.864 2005 1.000 0.659 0.876 1.211 1.266 9.235 1.917 1.221 1.451 7.696 13.512 2.633 3.250 2006 1.000 0.661 0.866 1.231 1.237 9.593 1.895 1.206 1.460 7.792 15.326 2.707 3.534 2007 1.000 0.669 0.864 1.270 1.233 9.989 1.929 1.211 1.477 7.964 16.692 2.808 3.698

14

Figure 4: Changes of nominal exchange rate from 2000 to 2008

190

170
% Change (E) US Dollar Pound Euro Real Yen Rupee Yuan Can $ Aus $ Peso Rouble Rand Riyal

xchange Rate

Dec-00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Dec-01 100.00 102.99 104.63 118.97 114.91 103.10 100.00 106.00 108.89 95.42 107.80 157.89 100.00

Dec-02 100.00 92.54 88.89 182.05 104.39 102.67 100.00 105.33 98.89 108.64 113.12 113.16 100.00

Dec-03 100.00 82.92 73.49 148.21 93.86 97.33 100.00 86.00 73.89 116.96 103.90 86.84 100.00

Dec-04 100.00 77.74 68.59 136.41 90.35 92.83 100.00 80.00 71.67 116.02 98.58 75.00 100.00

Dec-05 100.00 86.27 77.81 117.95 103.51 96.26 97.83 78.00 75.56 110.61 102.13 83.55 100.00

Dec-06 100.00 76.54 70.68 109.74 104.39 95.07 95.10 78.00 70.56 112.49 93.26 92.76 100.00

Dec-07 100.00 75.76 63.42 91.28 97.47 83.88 88.16 66.00 63.33 113.63 87.23 90.13 100.00

Jun-08 100.00 75.00 58.60 82.05 93.32 91.76 82.85 68.03 57.87 107.08 83.33 102.63 100.00

150

Figure 5: Changes of real (CPI) exchange rate from 2000 to 2008

170

% Change (e) United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa Saudi Arabia

ange Rate
Dec-00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

150
Dec-01 100.00 103.48 104.12 112.21 117.50 100.82 100.85 106.87 107.23 92.82 90.18 151.70 102.69 Dec-02 100.00 93.61 88.54 157.46 110.25 98.69 104.08 104.66 96.77 102.35 83.65 101.95 104.92 Dec-03 100.00 84.58 73.13 121.22 101.30 91.66 104.77 85.29 71.96 107.97 68.87 75.33 106.24 Dec-04 100.00 80.71 68.85 108.82 100.69 87.11 104.12 80.22 70.25 105.13 60.81 66.26 109.37 Dec-05 100.00 90.71 79.02 93.43 119.65 89.57 103.48 79.24 74.50 100.31 57.84 73.83 112.31 Dec-06 100.00 80.29 72.21 87.22 123.36 86.37 101.62 79.92 69.09 100.53 49.39 80.29 112.67 Dec-07 100.00 81.07 65.43 73.27 119.88 74.42 91.55 68.75 62.70 101.86 44.10 75.82 112.63 Jun-08 100.00 NA 61.20 65.50 116.75 79.22 NA 72.13 58.32 97.03 38.30 84.34 107.07

130

Figure 6: Wage increase in different countries from 2000 to 2008 (source: ref. 1, 3 to 14)

670

% Wage Increase United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa

2000 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

2001 3.59 3.42 2.67 8.26 -0.96 2.53 16.08 1.42 3.30 12.58 45.75 9.56

570

2002 4.79 7.24 5.31 15.51 -3.85 5.80 32.57 3.56 6.92 20.10 96.13 21.34

2003 6.84 11.25 7.50 11.63 -3.95 9.67 49.67 4.97 10.87 28.75 147.37 26.13

2004 10.60 16.24 9.55 10.50 -4.72 13.79 70.58 7.18 14.22 34.80 203.19 38.02

2005 12.65 20.55 11.59 12.76 -3.75 23.87 95.01 10.63 20.21 42.32 284.84 39.88

2006 16.58 25.54 14.05 18.39 -2.79 29.29 123.47 13.93 25.77 51.40 378.36 52.51

2007 19.66 30.33 16.17 50.68 -3.08 36.88 NA 17.58 30.73 -31.18 511.47 NA

2008 22.91 32.09 NA 57.20 -19.92 41.23 NA 20.44 31.58 NA 666.31 NA

se

470

Figure 7: Relative purchasing power parity from 2000 to 2008 after adjusting for wage increase

1.3

1.2
Rel. PPP adj for wage United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa 2000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 2001 1.000 0.997 1.014 1.014 1.023 1.033 0.885 1.013 1.018 0.946 0.850 0.984 2002 1.000 0.966 0.998 1.049 1.032 1.030 0.759 1.018 1.002 0.926 0.723 0.959 2003 1.000 0.941 0.997 1.170 1.031 1.034 0.681 1.026 0.989 0.899 0.652 0.976 2004 1.000 0.916 1.002 1.255 1.042 1.036 0.623 1.029 0.988 0.905 0.591 0.907 2005 1.000 0.889 0.989 1.261 1.013 0.977 0.546 1.002 0.950 0.873 0.517 0.911 2006 1.000 0.885 0.993 1.239 1.015 0.993 0.488 0.999 0.947 0.862 0.460 0.883 2007 1.000 0.858 0.988 0.989 1.004 0.985 0.448 0.977 0.925 1.940 0.387 NA 2008 1.000 0.000 NA 0.979 1.227 1.008 NA 0.962 0.927 NA 0.349 NA

1.1

es

Figure 8: Real exchange rate from 2000 to 2008 after adjusting for wage increase

160.0

Rate adj. for wages

140.0
2001 100.00 103.64 105.05 107.37 122.90 101.86 89.99 109.16 107.53 85.40 64.09 143.43 2002 100.00 91.47 88.04 142.85 120.15 97.74 82.26 105.89 94.84 89.29 44.69 88.04 2003 100.00 81.22 72.55 116.02 112.67 89.29 74.79 86.81 69.34 89.59 29.74 63.81 2004 100.00 76.79 69.29 108.91 116.87 84.67 67.51 82.78 68.02 86.26 22.18 53.09 2005 100.00 84.76 79.38 93.34 140.04 81.46 59.78 80.68 69.82 79.40 16.93 59.46 2006 100.00 74.56 73.27 85.88 147.94 77.87 53.02 81.77 64.05 77.41 12.04 61.37 2007 100.00 74.43 66.73 58.18 148.00 65.06 42.60 69.97 57.39 NA 8.63 NA

% Change e adj. for Wage United States United Kingdom European Union Brazil Japan India China Canada Australia Mexico Russia South Africa

2000 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

120.0

Table 1: Market exchange rate from 2000 to 2008

Nominal Exchange Rate (E) US Dollar British Pound Euro Brazilian Real Japanese Yen Indian Rupee Chinese Yuan Canadian Dollar Australian Dollar Mexico Peso Russian Rouble South African Rand Saudi Arabian Riyal Dec-00 1.0 0.7 1.1 2.0 114.0 46.8 8.3 1.5 1.8 9.6 28.2 7.6 3.8 Dec-01 1.0 0.7 1.1 2.3 131.0 48.2 8.3 1.6 2.0 9.2 30.4 12.0 3.8 Dec-02 1.0 0.6 1.0 3.6 119.0 48.0 8.3 1.6 1.8 10.4 31.9 8.6 3.8 Dec-03 1.0 0.6 0.8 2.9 107.0 45.5 8.3 1.3 1.3 11.2 29.3 6.6 3.8 Dec-04 1.0 0.5 0.7 2.7 103.0 43.4 8.3 1.2 1.3 11.2 27.8 5.7 3.8 Dec-05 1.0 0.6 0.8 2.3 118.0 45.0 8.1 1.2 1.4 10.6 28.8 6.4 3.8 Dec-06 1.0 0.5 0.8 2.1 119.0 44.4 7.9 1.2 1.3 10.8 26.3 7.1 3.8 Dec-07 1.0 0.5 0.7 1.8 111.1 39.2 7.3 1.0 1.1 10.9 24.6 6.9 3.8 Jun-08 1.0 0.5 0.6 1.6 106.4 42.9 6.9 1.0 1.0 10.3 23.5 7.8 3.8

Table 2: Weekly Wages from 2000 to 2008

Weekly Wage (in US$) United States United Kingdom European Union* Brazil Japan India China Canada Australia Mexico Russia South Africa

2000 585.0 528.6 363.5 98.3 663.6 14.4 21.7 437.0 373.7 77.1 19.7 164.1

2001 606.0 530.9 356.7 89.4 571.9 14.3 25.2 418.2 354.5 91.0 26.6 113.9

2002 613.0 612.6 431.0 62.4 611.2 14.8 28.7 429.7 404.0 85.3 34.2 176.0

2003 625.0 709.3 532.7 74.0 679.1 16.2 32.4 533.4 560.8 84.9 46.9 238.4

2004 647.0 790.5 582.5 79.6 699.8 17.6 37.0 585.5 595.6 89.6 60.6 302.1

2005 659.0 738.6 523.9 93.9 617.0 18.5 43.2 619.9 594.6 99.3 74.3 274.8

2006 682.0 867.0 590.9 106.0 618.0 19.6 50.9 638.4 666.1 103.8 101.1 269.9

2007 700.0 909.4 672.5 162.2 659.9 23.5 63.2 778.6 771.4 138.1

2008 719.0 931.0 0.0 188.3 569.4 22.1 0.0 773.8 849.7 181.2

Note*: The EU wage is an average of Germany, France, Italy and Spain.

PURCHASING POWER PARITY

The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the theory states that, in ideally efficient markets, identical goods should have only one price. This purchasing power SEM rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries, rather than just a nominal gross domestic product (GDP) comparison. The best-known and most-used purchasing power parity exchange rate is the GearyKhakis dollar (the "international dollar"). PPP exchange rates (the "real exchange rate") fluctuations are mostly due to market exchange rates movements. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of nontraded goods and services are usually lower where incomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. There can be marked differences between PPP and market exchange rates. [1] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese Yuan by purchasing power parity [2] - considerably different from the nominal exchange rate that put one dollar equal to 7.6 Yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.

First, lets look at the situation of domestic buying. Gustav Cassel developed the purchasing power parity (PPP) theory in 1920 to compare the purchasing power of different currencies in their home countries based on the assumption that identical goods should have the same price (law of one price). PPP exchange rate is defined in Equation 1:
PPP = P Dom P For

(Eq. 1)

Where PDom is domestic price and PFor is foreign price.

The relative purchasing power parity relates the inflation rate (change of prices) in each country to the change in the market exchange rate and is given in Equation 2:

PPPrel =

For Pt For / Pt 1 Dom Pt Dom / Pt 1

(Eq. 2)

Where Pt is the price level in period t. To calculate the relative purchasing power parity of all of the goods and services consumed in a country, we can substitute Pt with the consumer price index (CPI) of that country, which leads to Equation 3:

PPPrel =

CPI tFor / CPI tFor 1 Dom Dom CPI t / CPI t 1

(Eq. 3)

Figure 1 shows the consumer price indexes of thirteen relatively large countries or economies. The inflation rate is higher in the emerging economies than in the developed countries because of the higher rate of economic growth.

Figure 2 shows the changes in relative purchasing power parity of the above economies calculated by Equation 3. By this calculation, one may conclude that the US dollar has appreciated against the Mexican, Indian, South African, Brazilian, and Russian currencies by 10% to 217% while depreciated against the Australian, European, Canadian, British, Chinese, and Saudi Arabian currencies by 1% to 10% from 2000 to 2008 if the consumptions are domestic. This can be attributed to the difference in inflation rate of these countries. Japans disinflation condition between 2000 and 2008 caused the US dollar to weaken approximately 20% over the same time period.

The International Monetary Fund (IMF) has conducted similar calculation that includes more factors such as gross domestic product (GDP). The PPP exchange rates published by the IMF are displayed in the following Figure 3. The data shown in Figure 2 are consistent with the IMF data.

It was recognized by many economists that the PPP exchange rate calculation is not perfect because of the difficulties in finding the same baskets of goods to compare across countries. The weighing of goods and services in the CPI index is not identical among different countries. Often times, the quality of goods and service purchased varies considerably, for example, Americans probably drive better cars and drink cleaner water than many people in developing countries. Moreover, many social benefits offered by the welfare countries may not be included in the CPI calculations, and this makes direct comparison of purchasing power difficult. Nevertheless, this methodology gives us a rough idea how consumers are doing in different economies.

REAL EXCHANGE RATE IN INTERNATIONAL TRADE

When consumers or businesses purchase goods and services from foreign countries, they will need to exchange the available domestic currency to foreign currencies in order to fulfill the trade. The price of one currency in terms of another currency is called the exchange rate, and it is determined by the currency market and in some cases by individual governments. The exchange rates of twelve foreign currencies to the US dollar from 2000 to 2008 are shown in Table 1. The US dollar depreciated against most currencies in terms of market exchange rate after 2002, except for the Mexican Peso and Brazilian Real (until 2006).

Many people misunderstand the real prices if only the nominal (market) exchange rate is considered for the trade. For example, a three-bedroom apartment in China costs about 1,500,000 Yuan while a similar apartment in the US cost about 400,000 Dollar. A postdoctorate position in Oxford University in England is paid about 40,000 Pound per year while a similar position in Massachusetts Institute of Technology in the US is paid 60,000 Dollar per year. The market exchange rates do not reflect the real difference of the prices. Therefore, the real exchange rate which considers both the nominal exchange rate and prices should be used for international trade. The real exchange rate is defined in Equation 4:
Re al Exchange Rate (e) = No min al Exchange Rate ( E ) P Dom P For

(Eq. 4)

where PDom is domestic price, and PFor is foreign price. Using the above two examples, the real exchange rates would be 1.8 Chinese apartment = 1 American apartment, and 0.75 Oxford salary = 1 MIT salary in 2008.

If we substitute prices with CPI indexes in the above equation, the real exchange for all the goods and services can be estimated by Equation 5:
e = E CPI Dom CPI For

(Eq. 5)

Figure 4 and Figure 5 show the percent changes of nominal exchange rate and real (CPI) exchange rate from 2000 to 2008 and the values are not the same. When inflation (price change) rates are taken into account, the dollar actually strengthens against the Japanese Yen and Saudi Arabian Riyal while the advantage over the Peso and the Real (until 2005) diminished. The magnitude of depreciation of the US dollar against the British Pound, the Euro, the Canadian Dollar, and the Chinese Yuan is 2-5% better in the real rate than in the nominal rate. On the other hand, the dollar depreciated more against the Indian Rupee, the South African Rand (after 2002), and the Russian Ruble in the real rate than in the nominal rate. The real rate and the nominal rate for the Australian dollar are very similar. This analysis indicates that one would make different decisions in buying foreign goods and services when using the real exchange rate versus the nominal exchange rate.

In addition, if we compare the data in Figure 2 and Figure 5, it is obvious that the PPP exchange rate fluctuates less dramatically than the foreign exchange rate (except the Russian Ruble). In other words, foreign exchange rates affect international trade more than domestic consumption.

WAGE FACTOR

Most consumers except the unemployed and retirees earn wages to make a living. Employers usually give employees a small wages increase every year to offset inflation. Figure 6 shows the percentage of wage increase in different countries. The wage increase in the US, EU, and India is a few percent less than inflation over eight years while the wages in Canada, Brazil and Australia outpaced inflation by a few percents in the same period. The wage increase in UK, Mexico, South Africa, China and Russia is even faster,

double to triple digits gain over inflation is observed in these nations. Japans wage is stagnant (or dropping slightly) from 2000 to 2008. It is unclear what exactly causes these differences; one may speculate that it may relate to the fiscal condition and account balance of the nations as well as how the governments want to regulate their economy. For example, commodity producing countries is benefited from the recent purge of commodity prices; China has a large trade surplus; the Japanese prices may have come down from a very high level from decays ago. It will be interested to see how the fast wage increase in some nations would impact their inflation situation in the future.

The difference in wage changes certainly would have an impact to consumers purchasing power. If we modify Equation 3 and Equation 5 for calculating relative PPP and real (CPI) exchange rate by a wage factor, the following equations will results:

Dom CPI tFor / CPI tFor Wt Dom / Wt 1 1 PPPrel = For CPI tDom / CPI tDom Wt For / Wt 1 1

(Eq. 6)

e = E

CPI Dom W Dom CPI For W For

(Eq. 7)

where W denotes wages. Using this modified calculation, both domestic and foreign purchasing power will change. Figure 7 and Figure 8 shows the relative PPP and real exchange rate after adjusting for wage increase. After adjusting for wages, the relative PPP become almost the same for the US, EU, Canada, Japan (until 2007), India and Brazil (after 2006). Australia, UK, South Africa, Mexico become the out performers, which is not the case without adjusting for wages. China and Russia demonstrate the best improvement in relative PPP because of the large increase of their wages.

After adjusting for wages, the buying power of Americans in international markets weakens further relative to most foreign consumers except the Japanese. Meanwhile, the depreciation of the US dollar against the Euro is about 5% less than before adjustment (using the 2008 figure) because of the wage advantage for Americans. As pointed out earlier, there are pitfalls for direct cross-comparison using the CPI index. Additionally, other factors such as taxation may complicate the purchasing power calculation. For example, American income taxes are less than many industrialized countries while poorer nations probably dont tax on income as much.

Based on the above analysis, the emerging economies have made big progress in enhancing the international purchasing power of their citizens, thanks to increases of international trade, employment and work force productivity. Having said that, the gap of incomes between citizens of developed and developing countries are still quite large as shown in the Table 2. Additionally, the consequences of environmental damages and increased energy consumptions in developing countries due to rapid industrialization may be debatable issues.

Conclusion
Exchange rate, prices/inflation and wage level influence the purchasing power of consumers in domestic and international markets. The domestic purchasing power is mainly affected by the inflation rate of individual countries, and it is relatively equitable across mature economies. The international purchasing power is more volatile and is affected by both exchange rate and prices. Wage changes can further compensate or deprive purchasing power of consumers. Analysis of current exchange rates, prices and wages leads to the belief that foreign shoppers can get better bargains in Japan and the US at the present time. Consumers in emerging economies especially China and Russia have experienced significant improvement in purchasing power recently when compared to themselves. They may catch up with the living standard of rich countries in the future if this growth rate sustains. Finally, it will be interesting to research the fundamental economic forces which influence the gauges that are measured in the article. When prices are rising, you can buy less with a given amount of money. When hotdogs are expensive, a given amount of money will buy a small number of hotdogs. But when hotdogs are inexpensive, that is the price is low, your given hot dog allowance will purchase a lot more satisfaction. There is a relationship between prices and purchasing power that is a reciprocal relationship and thats the relationship that were going to be studying in this lesson. When prices are going from low prices to high prices, that is when there is inflation in the economy, the value of the dollar is shrinking, that is your Purchasing power is going from being able to buy a lot to being able to buy a little. In this lesson, Im going to begin by giving a simple numerical example, and then well talk about how you can use the GDP deflator to show the relationship between the inflation rate and purchasing power. Lets start by assuming that we are in a period of inflation and lets let hotdogs be a representative good, that is the price of all goods and services across the economy is increasing at some general rate and were going to look at the price of hotdogs in order to infer what is happening to purchasing power as prices are rising. Were going to be focusing now on the reciprocal relationship between the price level and the purchasing power of the dollar, that is, what a dollar will buy as the price level is changing. And Ive written out here as clearly as I can the formula that shows this reciprocal relationship, that is, one over the price level equals the purchasing power of a dollar. Let me make this very clear. Lets suppose that the price of a hotdog is five cents. Well, whats the purchasing power of your dollar? Five cents is the same thing as one twentieth of a dollar. Therefore the reciprocal of one twentieth is twenty. Your dollar will buy twenty hotdogs. Thats its purchasing power.

Now suppose were in a period of inflation, so that prices are rising, and the price of a hotdog goes up to two dollars. Whats happened to your purchasing power? Well, your dollar will no longer buy even a whole hotdog. Two dollars, or 2, has a reciprocal of one half, that is, you can now only afford half a hotdog. Your purchasing power has shrunk from twenty hotdogs at a price of five cents a piece, to one half a hotdog whenever the price is two dollars per hotdog. This simple example makes clear that the price level and the purchasing power of the dollar are reciprocals. Now, lets look at some examples using the GDP deflator. Suppose that were in the year 2000, which is our base year for calculating the GDP deflator and we calculate the price of a market basket of goods and services- that is, a little bit of Housing and a little bit of transportation, a little bit of medical care, a little bit of clothing, etc. And were going to call the price level in the year 2000 one hundred because its our base year. We look at those prices again in 2002, and we find that the price of the goods and services, as a ratio of the same prices in 2000 is equal to 104. That is, prices have increased by about 4 percent between the year 2000 and 2002. So if we write the GDP deflator, not in the form we usually write it that is multiplied by 100 to get 104 but lets write it now as in hundredths, 1.04, to show the 4 percent increase in prices between the year 2000 and 2002. Well, whats happened to the purchasing power of a dollar between the year 2000 and 2002? That is, how much can we afford to buy in 2002 with a dollar if we measure it in the prices of the year 2000? Prices are higher in 2002; therefore the dollar wont buy as much. Well if you take the reciprocal of the GDP deflator 1.04, you get 0.96. Whats that saying? Its saying that what you could have bought for 96 cents back in the year 2000, now it costs you a dollar to buy in 2002. That is a dollar in 2002, is only worth what 96 cents was worth back in the year 2000. You can afford to buy less. Your purchasing power has shrunk by about 4 percent. Your purchasing power shrinks at the same rate that the price level increases, because the price level and your purchasing power are reciprocals of each other. Well, lets take another example, during a period of deflation. If we look at the years between 1929 and 1933, well see falling prices. If we choose 1929 as the base year, and if we call the price level in that 200000, or 1.00, if we look at prices in 1933 during the great depression, we see that the price level has fallen by about 24 percent. That is weve gone from 1.00 down to 0.76. So we now have lower prices in 1933 than we had in 1929. Now what does that mean? What is going to happen to the purchasing power of your dollar when prices are lower? Its clearly going to increase. Youre going to go from a small purchasing power to a bigger purchasing power. And if you take the reciprocal of 76 percent, you get 1.32. That is, the purchasing power of the dollar has increased by about 32 percent in this example. Now the reason the numbers dont add up exactly, the reason I cant say a 24 percent decrease in prices is equal to a 24 percent increase in purchasing power is because once your percentages start getting large, you run into this problem that a fifty percent increase is, sorry, that a 100 percent increase is the reciprocal of a 50 percent decrease you wind up with this problem that weve

discussed earlier about the calculation of percentage changes but you can still use this formula any time, it always works. One over the price level gives you the purchasing power of the dollar and when the price level is only 76 percent what it was before, your purchasing power is going to be 132 percent of what it was before. Falling prices give us an increase in the purchasing power of the dollar.

REFERENCES

1. http://www.worldsalaries.org/ 2. International Monetary Fund, World Economic Outlook Database, September 2006 3. Website of Australian Bureau of Statistics 4. Website of Blanco de Mexico 5. Website of Bank of England 6. Website of Central Bank of Brazil 7. Website of European Central bank 8. Website of International Organization of Labor 9. Website of the Labor Department of India 10. Website of the Ministry of Economics and Planning of Saudi Arabia 11. Website of the Ministry of Finance of the Russian Federation 12. Website of National Bureau of Statistics of China 13. Website of Statistics Bureau of Japan 14. Website of Statistics Canada 15. Website of Statistics South Africa 16. Website of the United States Labor Department 17. Website of Wikipedia on purchasing power parity and consumer price index