This could be a silly question, but I'm a bit confused with this concept.

Don't we say usually the purchasing power(or value) of currency(or money) is low when the price level is high in one country(i.e. negative relationship)?

However, in international economics, it looks like a country's price level has postive relation to purchasing power of it's own currency.

For example, the prices of United States are higher than that of Korea and at the same time, the purchasing power of dollar is higher than Korean won.

How can I understand this kind of contradiction?

  • 1
    $\begingroup$ PPP is not purchasing power of currency it is purchasing power parity. It is a number that gives you an ‘exchange rate’ at which two currencies (let’s say USD and EUR) are at a parity (when they are equal to each other). You can use it for international comparison of purchasing power but it’s not an absolute metric $\endgroup$
    – 1muflon1
    May 14 '21 at 16:19

Prices in themselves don't mean much when you want to predict purchasing power.

Imagine a loaf of bread costs 100 of country A's monetary units in country A, while it costs 2 of country B's monetary units in country B. This does not tell you anything about purchasing power because you do not know if you could buy a loaf of bread for 100 of country A's monetary units in country B or vice versa.

You also need to consider the currency A to currency B exchange rate, usually denoted by $E_{B/A}$. Then purchasing power/real exchange rate is calculated by
$$ \frac{P_A}{P_B} \cdot E_{B/A} , $$ where $P_A$ and $P_B$ are price levels in countries A and B respectively. If this is larger than 1, then using country A's currency one could buy more goods in country B than in country A, while if it is smaller than 1 then the reverse is true.

  • $\begingroup$ Thanks for your comment :) I am still struggling with the result when real exchange rate q(b/a)=(Pa/Pb)*E(b/a) is larger than one, that is 'actual nominal exchange rate > PPP based nominal exchange rate'. In this situation, It looks like country A's currency has higher purchasing power than B, but at the same time prices of country A are higher than B. How can we justify that currency's purchasing power and prices of one country are positively related in this situation? $\endgroup$
    – modernyoon
    May 15 '21 at 5:06
  • $\begingroup$ What do you mean by "How can we justify"? My answer explains that prices alone do not determine purchasing power, you also need to consider the exchange rate. So depending on the exchange rate, either currency can have "more purchasing power". $\endgroup$
    – Giskard
    May 15 '21 at 6:39
  • $\begingroup$ Oh I see... The result that a rise in one country's price level holding actual(spot) exchange rate constant raises the purchasing power of that country's currency seems contradictory to me, because usually high prices lead to low value of currency. However, change in price level will affect exchange rate so we should evaluate purchasing power considering both exchange rate and prices. I think I get the point. Thanks it helped a lot! $\endgroup$
    – modernyoon
    May 15 '21 at 14:04

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