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What’s it? Purchasing power parity (PPP) is an economic concept for equalizing the price of a set of identical items across different locations. In other words, these goods should be priced at the same level in various countries.
The concept works under the law of one price. The difference in prices in the two countries should reflect their nominal exchange rates. So, when you adjust the prices for the exchange rate, the two countries’ prices will be equal.
The law assumes no transportation costs, transaction costs, or trade barriers. And that assumption is, of course, unrealistic in practice. As a result, PPP exchange rates can differ from market rates due to these factors.
Why purchasing power parity matters
Purchasing power parity is widely used to convert several economic indicators, such as gross domestic product (GDP). Converting them makes the data more comparable between countries because it eliminates the effect of exchange rate differences.
Purchasing power parity is determined by comparing the prices of buying a bundle of goods and services in each country. This information is then used to convert each country’s GDP into common monetary units such as US dollars. Conversions make GDP comparisons more relevant.
Furthermore, PPP is also useful for capturing differences in the cost of living in each country. The World Bank, for example, uses a price ratio of PPP conversion factor to adjust the GDP figures for each country. It measures the difference in the prices for all goods and services produced in a country.
For Germany, the ratio was 0.8 in 2023. That means, for USD1 worth of goods and services purchased in the United States, it costs USD0.8 in Germany. That shows that to consume the same goods, prices are slightly lower in Germany.
How to calculate purchasing power parity
Purchasing power parity (PPP) helps us understand the relative cost of living between countries, independent of exchange rates. It works under the law of one price, which states that a basket of goods should cost the same in different countries once exchange rates are considered. We can calculate PPP using the following formula:
- PPP exchange rate (Domestic currency per foreign currency) = Domestic price of basket / Price of basket abroad
Here’s what each part represents:
- PPP exchange rate: This is the exchange rate adjusted for purchasing power. It tells you how much of the domestic currency you need to buy the same basket of goods available in the foreign country.
- Domestic price of basket: This is the total cost of buying the basket of goods in your home country.
- Price of basket abroad: This is the total cost of buying the same basket of goods in a foreign country.
Example: Comparing Chicago and Paris
Let’s create a basket representing typical expenses on a trip:
- Chicago: Lunch at a cafe (USD12), movie tickets (USD15), museum entry (USD20) – Total cost: USD 47
- Paris: Lunch at a cafe (EUR15), movie tickets (EUR18), museum entry (EUR22) – Total cost: EUR55
Step 1: Convert Euro price to USD (assuming a known exchange rate):
Suppose the exchange rate is USD 1.2 per EUR. So, the basket in USD would cost:
- USD price = EUR price x USD per EUR
- USD price = EUR55 x USD 1.2 per EUR
- USD price = USD 66
Step 2: Calculate the PPP exchange rate (USD per EUR):
Now that both basket prices are in USD (using PPP logic), we can use the formula:
- PPP exchange rate (USD per EUR) = USD 47 (Chicago basket) / USD 66 (Paris basket)
- PPP = 0.71 USD per EUR
This PPP exchange rate suggests that, based on this basket, you’d need slightly less than USD 0.71 to purchase the same amount of goods in Paris compared to Chicago (considering the exchange rate of USD 1.2 per EUR). However, keep in mind that PPP is an estimate, and actual prices might vary depending on specific goods and services.
While the PPP calculation suggests Paris might be slightly more expensive than Chicago for this specific basket, it’s a helpful starting point. Remember, PPP doesn’t account for everything, so research specific costs like accommodation and transportation before your trip.
Types of purchasing power parity
Purchasing power parity (PPP) is a powerful tool, but it comes in two types: absolute PPP and relative PPP. Understanding the difference is crucial for accurate economic comparisons across borders.
Absolute PPP: Imagine a world where identical goods cost the same everywhere, regardless of currency. That’s the core idea behind absolute PPP. It proposes a theoretical exchange rate where the ratio of price levels in two countries directly translates to the exchange rate.
- Absolute PPP Exchange Rate = Price Level in Country A / Price Level in Country B
- Price Level: This represents the average cost of goods and services in a country.
In simpler terms, absolute PPP calculates the exchange rate that would equalize the purchasing power of currencies when buying a basket of goods.
Absolute PPP assumes perfect arbitrage, meaning there are no transportation costs, trade barriers, or quality variations between goods in different countries. In reality, these factors exist, making absolute PPP a theoretical ideal rather than a perfect reflection of reality.
Relative PPP: While absolute PPP offers a theoretical picture, relative PPP focuses on the dynamic aspect. It states that changes in price levels between countries should be reflected in changes in the exchange rate over time.
Relative PPP is more concerned with trends than absolute values. It suggests that if inflation (price increase) is higher in one country compared to another, the first country’s currency should weaken (devalue) relative to the second country’s currency over time.
Benefits of PPP
Purchasing power parity (PPP) goes beyond theory. It offers a practical toolkit for understanding economies across the globe. Let’s delve into its key benefits:
Unveiling the true size of economies: comparing GDP apples to apples. Imagine comparing the Gross Domestic Product (GDP) of the US and China. While the raw numbers are impressive, currency differences can cloud the picture. PPP comes to the rescue! By converting GDP to a common currency using PPP exchange rates, we get a clearer picture of a country’s true economic output relative to others. This allows for a more meaningful comparison of economic size and development.
Beyond currency values: gauging living standards. Purchasing power parity isn’t just about money; it’s about what money can buy. PPP helps us understand the standard of living in different countries. By comparing the cost of a basket of goods using PPP exchange rates, we can see if your dollar stretches further in Indonesia or Germany, for instance. This provides valuable insights for travelers and those considering relocation.
Predicting the future? PPP and exchange rate trends. While not a perfect crystal ball, PPP sheds light on long-term exchange rate trends. The theory suggests that market exchange rates tend to gravitate towards PPP exchange rates over time. This can be helpful for investors to understand potential currency fluctuations that might impact their investments in different countries.
A reliable compass: countering currency manipulation. Governments sometimes intervene in currency markets to gain an advantage. PPP provides a more reliable benchmark in such situations. By comparing market exchange rates to PPP exchange rates, we can identify potential currency manipulation and get a clearer picture of a country’s economic fundamentals.
Limitations of PPP
Purchasing power parity (PPP) is a powerful tool, but it’s not without limitations. Here’s a closer look at the factors that can make PPP calculations less than perfect:
The elusive “identical basket”: Imagine comparing a basket of groceries in France and India. Apples might be apples, but quality and variety can differ. PPP struggles to define a truly identical basket of goods across countries due to:
- Quality variations: The same product might have different qualities in different countries. For example, a “flat-screen TV” in China might not offer the same resolution as one in Japan.
- Consumer preferences: People have different tastes. What’s considered a “basic good” in one country might be a luxury in another. French cheese might not be a staple in every basket!
Ignoring the real world: transportation and trade barriers: PPP assumes the “law of one price,” where identical goods should cost the same everywhere, adjusted for currency. However, this doesn’t account for:
- Transportation costs: Shipping a basket of goods from France to India adds a cost not reflected in PPP calculations.
- Trade barriers: Tariffs and import restrictions can artificially inflate prices in certain countries.
The data dilemma: accuracy and availability. Measuring PPP perfectly is a challenge due to:
- Vast product numbers: The sheer number of goods and services makes it difficult to track prices accurately.
- Limited data: Data on prices and consumption patterns may not be readily available, especially for developing economies.
- Local products: Some goods might only be available in specific countries, making comparisons even harder.
In essence, while PPP offers valuable insights, it’s important to acknowledge its limitations. The quality of goods, transportation costs, and data availability can all influence the accuracy of PPP calculations.
