And what do people mean when they say one currency is “stronger” than another?
In: Economics
Let’s say you have country A and country B. Country A uses green pieces of paper for money, country B uses blue pieces of paper.
Currently the average income in country A is 50,000 pieces of green paper per year. The average income in country B is 25,000 pieces of blue paper per year. The exchange rate for green paper to blue paper is 2/1. Meaning when you exchange your money, 2 pieces of green paper buy you 1 piece of blue paper.
So that means the average income is the same, right? Not necessarily. Now we get into purchasing power parity. While on paper the incomes look the same, it may be that the stuff in country B is just cheaper than the stuff in country A. Whether it’s due to taxes, a worse transportation system, less land available, or whatever, country A is more expensive to live in. You buy a car in country A and you’re paying more than your counterpart buying the same car in country B.
Purchasing power parity is an attempt to determine how much you can really afford to buy.
Purchasing power is how much things you can buy for a given amount of money.
In country A you get your daily needs for 1000 Dollars in country B you get it for 100 Ducats.
If the exchange course Dollars to Ducats is 10:1 then both currencies are at Purchasing Power Parity.
Very often thats not the case though. If you take your dollars to india and exchange them for Rupees you can buy much more stuff for your money. That means the dollar is a stronger currency, independently of the actual exchange rate.
Since most people spend and earn money in the same country this mostly matters for import and export. If you have a strong currency buying foreign wares is easy, but exporting your goods to other places is harder since the foreign customers will have to pay a larger part of their income.
Purchasing power parity tries to better match income vs. costs. Income in one country may be 1/4 what it is in another country, but if rent, food, etc. also cost 1/4 then the purchasing parity is about even.
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