Originally posted on March 24, 2012.
Nick Rowe has a good method for introducing the concept of PPP:
1. I ask the class for a student volunteer. The student has to come from a country I know next to nothing about, and that has its own currency.
2. I ask the student for the name of the currency used in his home country, and he answers (say) “shillings”.
3. I then try to guess the exchange rate between the shilling and the Canadian dollar. I don’t have a clue. Nor does anyone in the class, except the volunteer. (Any student who is from the same country, or has visited it recently etc., is not allowed to guess).
4. I then ask the volunteer to tell me the price of a dozen eggs (or a cup of coffee, or whatever) in his home country. He tells me.
5. I remind the students that a dozen eggs costs about $2.50 in Canada. We then all have a second attempt to guess the exchange rate. For example, if the student says that a dozen eggs costs 10 shillings back home, I guess that the exchange rate is 4 shillings to one dollar.
6. The student then tells us the exchange rate, and we see how close our second guess is.
It usually works quite well. Because:
1. About half the students figure out PPP by themselves, and can explain it to the other half.
2. They learn that a theory can be false, but still useful. Our second guess using PPP is never exactly right, but it’s a lot better than our wild first guesses.
3. They learn the difference between a conditional forecast (the second guess) and an unconditional forecast (the first guess).
4. If our guess based on PPP is wrong (which it always will be, to some extent) I ask the student (rhetorically) why he doesn’t buy eggs where they are cheap, load up his suitcase with eggs, and sell them where they are dear, whenever he flies between Canada and home. That teaches students both the equilibrating mechanism behind PPP, and the limitations of PPP in a world with transportation costs and other restrictions on trade.
(Last time I tried it, my second guess failed badly. But a couple of other students Googled the price of eggs in the home country, and said it was very close to PPP, and much lower than what the student said. Maybe he rarely bought eggs himself. Maybe I should try another good that students frequently buy. I could use the Big Mac Index, but I don’t think that works as well pedagogically. After all, McDonalds is one company, and maybe they just choose to price that way.)