Factors affecting the price level ratio across countries with a focus on small states

Abstract

The objective of this paper is to analyse the factors that affect the ratio of market exchange rate (MER) to the purchasing power exchange rate (PER) with a focus on small states. The MER is the price of one currency in terms of another. The purchasing power exchange rate (PER) captures the number of units of a country‟s currency needed to purchase an identical quantity of goods and services in the corresponding country, as a US dollar would buy in the United States. If all products of a national economy are considered, the PER/MER ratio, also called the price level ratio, would represent the national price levels and would explain the price differentials across countries. It is to be expected that the MER will be influenced by the choice of currency in the particular country, for example, the exchange rate of the US dollar for the Japanese Yen is ¥106.64, while the exchange rate of the Euro is €0.82. The PER, in a way, adjusts this exchange rate in terms of purchasing power. It is likely that highly developed countries, where the cost of living is relatively high, compared to less developed countries, register higher PER.