External Purchasing Power Analysis

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Internal and External Purchasing Powers Having understood the price level concept and its relationship with price index we can then look into the two different purchasing power principles: internal and external. Internal purchasing power of a particular currency is a reflection of the value of how much a consumer can buy with the given amount of domestic currency in the particular country. In other words, that is the amount of goods and services that can be purchased with a pound in the United Kingdom, or alternatively a dollar in the United States. Over time the value of money is constantly decreasing and a pound 10 years ago could buy considerably more than a pound today. The CPI table is a perfect example that illustrates this process in real life: in 2013 consumer would have to spend £107.7 for goods that in 2010 could be bought for £100. Usually internal purchasing power level is measured in consumption bundles. That is how many of these consumption bundles can be bought for particular amount of domestic currency in home economy. For example if a consumption bundle of particular fixed goods and services in the UK costs £20,000 with £100,000 we could buy 5 of these bundles. This raises a question: if we would be able buy the same 5 bundles for £100,000 in the USA or any other country in the world? To answer this question we should analyse the external purchasing power. External purchasing power of a currency reflects the value of how much a consumer can buy with a particular amount of home currency in a different country. In order to determine the external purchasing power of a pound in the USA, as per our example, we would need to convert the pounds into dollars and then calculate how many consumption bundles we would be ... ... middle of paper ... ...2.80$ in the USA. As we can see the prices in most of the countries are completely different. With Switzerland being the most expensive country to buy both BigMac (5.11$) and a tall latte at Starbucks (4.54$) and the least expensive country for a BigMac being China (1.23$) and Thailand (1.93$) for the tall latte. The smaller table shows how strongly the local currency is either undervalued or overvalued against the US dollar. These valuations can be used to predict the appreciation or depreciation of a particular currency. Therefore it could be a reasonable factor to consider for the financial managers. Knowing how a particular currency would move in the future on the foreign exchange markets could prevent the managers from making decisions that might lead to a loss because of the fluctuations of currency in which most of the corporations transactions are settled.

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