Effect Of Exchange Rate, Inflation And Wages On The Purchasing

8th Global Conference on Business & Economics ISBN : 978-0-9742114-5-9

Effect of Exchange Rate, Inflation and Wages on the Purchasing Power of

Consumers in Different Economies

Jian Zhang

Harvard University Extension School, Cambridge, MA, USA

Barr Pharmaceuticals, Inc., Pomona, NY, USA

Tel: (845)362-2753

Fax: (845)362-2832

Acknowledgements

The author would like to thanks Dr. B. Watson for teaching the basic concepts of finance,

B. Kang and S.U. Ahmed for the helpful discussions on the subject, and E. Fitzpatrick for

proofreading the manuscript.

October 18-19th, 2008Florence, Italy

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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 consumer’s 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.

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


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wage level affecting the purchasing power of consumers who reside in various countries

in the world from 2000 to 2008.

PURCHASING POWER PARITY

First, let’s 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:

(Eq. 1)

where PDom is demoestic 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:

(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:

(Eq. 3)


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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. Japan’s 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


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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 post-

doctorate 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


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rate and prices should be used for international trade. The real exchange rate is defined

in Equation 4:

(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:

(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


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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. Japan’s 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


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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 consumer’s

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:

(Eq. 6)

(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 outperformers,

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


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(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 don’t 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.

CONCLUSIONS

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


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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.

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 Banco 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


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http://www.worldsalaries.org/


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


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Figure 1: Consumer price indexes of representative economies from 2000 to 2008

(source: ref. 3 to16)

50

150

250

350

450

550

650

2000 2001 2002 2003 2004 2005 2006 2007 2008

Con

sum

er P

rice

Inde

x (C

PI)

United StatesUnited KingdomEuropean UnionBrazilJapanIndiaChinaCanadaAustraliaMexicoRussiaSouth AfricaSaudi Arabia

CPI 2000 2001 2002 2003 2004 2005 2006 2007 2008 (May)United States 174.0 176.7 180.9 184.3 190.3 196.8 201.8 210.0 216.6

United Kingdom 93.7 94.7 96.3 97.3 98.7 100.8 103.6 105.7 NAEuropean Union 90.8 92.6 94.8 96.6 98.9 101.1 103.1 106.2 108.2

Brazil 100.0 107.7 120.2 129.5 137.1 142.8 145.9 150.4 156.0Japan 102.2 101.5 100.6 100.3 100.3 100.0 100.3 100.3 101.7India 441.0 458.0 477.0 496.0 514.0 536.0 563.0 600.0 636.0China 100.4 101.1 100.3 101.5 105.5 107.4 109.0 116.7 NA

Canada 97.0 97.7 101.5 103.6 105.8 108.0 109.8 112.4 113.9Australia 131.3 135.4 139.5 142.8 146.5 150.6 155.5 160.1 162.2Mexico 93.2 97.4 102.9 107.0 112.6 116.3 121.0 125.6 128.1Russia 100.0 121.4 140.6 159.8 177.3 199.7 219.0 238.8 270.9

South Africa 100.0 105.7 115.4 122.1 123.8 128.0 134.0 143.5 151.5Saudi Arabia 98.9 97.8 98.0 98.6 98.9 99.6 101.8 106.0 115.0


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

2008

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2000 2001 2002 2003 2004 2005 2006 2007 2008

Rel

ativ

e PP

P


Rel. PPP exchange 2000 2001 2002 2003 2004 2005 2006 2007 2008United States 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000






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

0

2

4

6

8

10

12

14

16

18

2000 2001 2002 2003 2004 2005 2006 2007

Nat

iona

l Cur

renc

y pe

r Int

erna

tiona

l Dol

lar

United StatesUnited KingdomGermanyBrazilJapan*IndiaChinaCanadaAustraliaMexicoRussiaSouth AfricaSaudi Arabia

Note*: x100 for Japanese currency.

Country 2000 2001 2002 2003 2004 2005 2006 2007United States 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000

United Kingdom 0.645 0.645 0.654 0.662 0.663 0.659 0.661 0.669Germany 0.934 0.923 0.919 0.912 0.893 0.876 0.866 0.864

Brazil 0.867 0.909 0.985 1.111 1.172 1.211 1.231 1.270Japan* 1.498 1.448 1.407 1.364 1.310 1.266 1.237 1.233India 8.473 8.570 8.630 8.803 9.006 9.235 9.593 9.989China 1.828 1.822 1.801 1.813 1.891 1.917 1.895 1.929

Canada 1.218 1.203 1.193 1.207 1.215 1.221 1.206 1.211Australia 1.362 1.380 1.393 1.406 1.421 1.451 1.460 1.477Mexico 6.195 6.411 6.737 7.171 7.501 7.696 7.792 7.964Russia 6.833 7.773 8.833 9.870 11.507 13.512 15.326 16.692

South Africa 2.110 2.219 2.413 2.476 2.569 2.633 2.707 2.808Saudi Arabia 2.678 2.526 2.554 2.649 2.864 3.250 3.534 3.698


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

75.00

58.60

82.05

93.3291.76

68.03

57.87

107.08

83.33

102.63100.00

50

70

90

110

130

150

170

190

2000 2001 2002 2003 2004 2005 2006 2007 2008

Perc

ent C

hang

e of

Nom

inal

Exc

hang

e R

ate

United StatesBritish PoundEuroBrazilian RealJapanese YenIndian RupeeChinese YuanCanadian DollarAustralian DollarMexico PesoRussian RoubleSouth African RandSaudi Arabian Riyal

% Change (E) Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Jun-08US Dollar 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Pound 100.00 102.99 92.54 82.92 77.74 86.27 76.54 75.76 75.00Euro 100.00 104.63 88.89 73.49 68.59 77.81 70.68 63.42 58.60Real 100.00 118.97 182.05 148.21 136.41 117.95 109.74 91.28 82.05Yen 100.00 114.91 104.39 93.86 90.35 103.51 104.39 97.47 93.32

Rupee 100.00 103.10 102.67 97.33 92.83 96.26 95.07 83.88 91.76Yuan 100.00 100.00 100.00 100.00 100.00 97.83 95.10 88.16 82.85Can $ 100.00 106.00 105.33 86.00 80.00 78.00 78.00 66.00 68.03Aus $ 100.00 108.89 98.89 73.89 71.67 75.56 70.56 63.33 57.87Peso 100.00 95.42 108.64 116.96 116.02 110.61 112.49 113.63 107.08

Rouble 100.00 107.80 113.12 103.90 98.58 102.13 93.26 87.23 83.33Rand 100.00 157.89 113.16 86.84 75.00 83.55 92.76 90.13 102.63Riyal 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00


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

100

81.07

61.2065.50

116.75

79.22

91.55

72.13

58.32

97.03

38.30

84.34

107.07

30

50

70

90

110

130

150

170

2000 2001 2002 2003 2004 2005 2006 2007 2008

Perc

ent C

hang

e of

Rea

l (C

PI) E

xcha

nge

Rat

e


% Change (e) Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Jun-08United States 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00






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

-30

70

170

270

370

470

570

670

2000 2001 2002 2003 2004 2005 2006 2007 2008

Perc

ent W

age

Incr

ease

United StatesUnited KingdomEuropean UnionBrazilJapanIndiaChinaCanadaAustraliaMexicoRussiaSouth Africa

% Wage Increase 2000 2001 2002 2003 2004 2005 2006 2007 2008United States 0.00 3.59 4.79 6.84 10.60 12.65 16.58 19.66 22.91

United Kingdom 0.00 3.42 7.24 11.25 16.24 20.55 25.54 30.33 32.09European Union 0.00 2.67 5.31 7.50 9.55 11.59 14.05 16.17 NA

Brazil 0.00 8.26 15.51 11.63 10.50 12.76 18.39 50.68 57.20Japan 0.00 -0.96 -3.85 -3.95 -4.72 -3.75 -2.79 -3.08 -19.92India 0.00 2.53 5.80 9.67 13.79 23.87 29.29 36.88 41.23China 0.00 16.08 32.57 49.67 70.58 95.01 123.47 NA NA

Canada 0.00 1.42 3.56 4.97 7.18 10.63 13.93 17.58 20.44Australia 0.00 3.30 6.92 10.87 14.22 20.21 25.77 30.73 31.58Mexico 0.00 12.58 20.10 28.75 34.80 42.32 51.40 -31.18 NARussia 0.00 45.75 96.13 147.37 203.19 284.84 378.36 511.47 666.31

South Africa 0.00 9.56 21.34 26.13 38.02 39.88 52.51 NA NA


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

increase

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

2000 2001 2002 2003 2004 2005 2006 2007 2008

Rel

. PPP

adj

. for

wag

es


Rel. PPP adj for wage 2000 2001 2002 2003 2004 2005 2006 2007 2008

United States 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000United Kingdom 1.000 0.997 0.966 0.941 0.916 0.889 0.885 0.858 0.000European Union 1.000 1.014 0.998 0.997 1.002 0.989 0.993 0.988 NA


Canada 1.000 1.013 1.018 1.026 1.029 1.002 0.999 0.977 0.962Australia 1.000 1.018 1.002 0.989 0.988 0.950 0.947 0.925 0.927Mexico 1.000 0.946 0.926 0.899 0.905 0.873 0.862 1.940 NARussia 1.000 0.850 0.723 0.652 0.591 0.517 0.460 0.387 0.349

South Africa 1.000 0.984 0.959 0.976 0.907 0.911 0.883 NA NA


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

100.0

74.4

66.7

58.2

148.0

65.1

42.6

70.0

57.4

77.4

8.6

61.4

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

2000 2001 2002 2003 2004 2005 2006 2007

Perc

ent C

hang

e in

Rea

l Exc

hang

e R

ate

adj.

for w

ages


% Change e adj. for Wage 2000 2001 2002 2003 2004 2005 2006 2007

United States 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00United Kingdom 100.00 103.64 91.47 81.22 76.79 84.76 74.56 74.43European Union 100.00 105.05 88.04 72.55 69.29 79.38 73.27 66.73

Brazil 100.00 107.37 142.85 116.02 108.91 93.34 85.88 58.18Japan 100.00 122.90 120.15 112.67 116.87 140.04 147.94 148.00India 100.00 101.86 97.74 89.29 84.67 81.46 77.87 65.06China 100.00 89.99 82.26 74.79 67.51 59.78 53.02 42.60

Canada 100.00 109.16 105.89 86.81 82.78 80.68 81.77 69.97Australia 100.00 107.53 94.84 69.34 68.02 69.82 64.05 57.39Mexico 100.00 85.40 89.29 89.59 86.26 79.40 77.41 NARussia 100.00 64.09 44.69 29.74 22.18 16.93 12.04 8.63

South Africa 100.00 143.43 88.04 63.81 53.09 59.46 61.37 NA


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Table 1: Market exchange rate from 2000 to 2008

Nominal Exchange Rate (E) Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Jun-08US Dollar 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0

British Pound 0.7 0.7 0.6 0.6 0.5 0.6 0.5 0.5 0.5Euro 1.1 1.1 1.0 0.8 0.7 0.8 0.8 0.7 0.6

Brazilian Real 2.0 2.3 3.6 2.9 2.7 2.3 2.1 1.8 1.6Japanese Yen 114.0 131.0 119.0 107.0 103.0 118.0 119.0 111.1 106.4Indian Rupee 46.8 48.2 48.0 45.5 43.4 45.0 44.4 39.2 42.9Chinese Yuan 8.3 8.3 8.3 8.3 8.3 8.1 7.9 7.3 6.9

Canadian Dollar 1.5 1.6 1.6 1.3 1.2 1.2 1.2 1.0 1.0Australian Dollar 1.8 2.0 1.8 1.3 1.3 1.4 1.3 1.1 1.0

Mexico Peso 9.6 9.2 10.4 11.2 11.2 10.6 10.8 10.9 10.3Russian Rouble 28.2 30.4 31.9 29.3 27.8 28.8 26.3 24.6 23.5

South African Rand 7.6 12.0 8.6 6.6 5.7 6.4 7.1 6.9 7.8Saudi Arabian Riyal 3.8 3.8 3.8 3.8 3.8 3.8 3.8 3.8 3.8

Table 2: Weekly Wages from 2000 to 2008

Weekly Wage (in US$) 2000 2001 2002 2003 2004 2005 2006 2007 2008United States 585.0 606.0 613.0 625.0 647.0 659.0 682.0 700.0 719.0

United Kingdom 528.6 530.9 612.6 709.3 790.5 738.6 867.0 909.4 931.0European Union* 363.5 356.7 431.0 532.7 582.5 523.9 590.9 672.5 0.0

Brazil 98.3 89.4 62.4 74.0 79.6 93.9 106.0 162.2 188.3Japan 663.6 571.9 611.2 679.1 699.8 617.0 618.0 659.9 569.4India 14.4 14.3 14.8 16.2 17.6 18.5 19.6 23.5 22.1China 21.7 25.2 28.7 32.4 37.0 43.2 50.9 63.2 0.0

Canada 437.0 418.2 429.7 533.4 585.5 619.9 638.4 778.6 773.8Australia 373.7 354.5 404.0 560.8 595.6 594.6 666.1 771.4 849.7Mexico 77.1 91.0 85.3 84.9 89.6 99.3 103.8Russia 19.7 26.6 34.2 46.9 60.6 74.3 101.1 138.1 181.2

South Africa 164.1 113.9 176.0 238.4 302.1 274.8 269.9

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


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Documents

Effect Of Exchange Rate, Inflation And Wages On The Purchasing