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October 1, 2015
USDA METSS Project
Aggregation level: Weighted averages of the PPP of the product groups where weights are the
expenditures on the product groups as established in national accounts
The basket of goods used in the estimation of the PPP is a sample of goods and services used in the
estimation of GDP. Final list is approximately 3,000 consumer goods and services, 30 government
occupations, 200 equipment and 15 construction projects. They also often generate a significant portion
of their domestic public revenues through imposed barriers to trade such as tariffs.
From the foregoing, the prevalence of poverty may be influenced by the changes in the prices of goods
in a country’s basket of goods when the assumption of zero transaction costs and absence of trade
barriers fail to hold. Most developing countries experience significant transaction costs in traded goods
because of their dependence on imports. The extent of the violation of the law of one price is
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exacerbated by the proportion of consumption that is imported and changing foreign exchange situation
in the country.
Research Question
To what extent do macroeconomic conditions in a developing country influence the prevalence of
poverty? The macroeconomic conditions of interest are exchange rates and inflation, measured by the
consumer price index (CPI). For simplicity purposes, the research question ignores the non‐trivial effect
of population growth on the prevalence of poverty.
The question is important because the performance of intervention projects aimed at reducing poverty
may be adversely affected by inimical macroeconomic conditions over which the projects have no
control. Understanding and measuring the effect of these macroeconomic conditions allow project
managers to make the necessary adjustments to their achievements to help effectively monitor and
evaluate project performance.
Background
Suppose the perfect world where the real exchange rate is constant over time between two countries,
say U.S. and Ghana. Suppose also that a basket of goods produced in U.S. and Ghana were identical and
completely tradable. The law of one price would suggest that net of transportation costs, arbitrage
would insure that the dollar price of the basket is identical between Ghana and the U.S. – this is the
basic theory of PPP determination.
Let us begin with an illustration of the changing PPP measured as national currency per U.S. dollar in the
Euro Zone and the UK (Figure 1). Between 2009 and 2014, UK’s PPP has been increasing while the EU’s
has been declining. This implies that for people living in the UK needed a declining quantity of British
Pounds to purchase the same basket of goods as would be purchased in the U.S. for given price in U.S.
dollars while those living in the Euro Zone needed an increasing quantity of Euros. A declining PPP is,
therefore, an indicator of a worsening economic condition for residents in a particular country.
Let us define the real exchange rate, Q, as follows:
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