Purchasing Power Parity: Formula, Calculation, Pros, Cons

What’s it: Purchasing power parity (PPP) is an economic concept for equalizing the price of a set of identical items across different locations. Long story short, 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 different countries should reflect the nominal exchange rates between the two. So when you adjust it 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). By converting them, the data will be 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 Indonesia, the ratio was 0.34 in 2019. That means, for USD1 worth of goods and services purchased in the United States, it costs USD0.34 in Indonesia. That shows, to consume the same goods, prices are lower in Indonesia.

The following is the PPP conversion factor price level ratio data for 2019 (data is accessed on 10 October 2020).

How to calculate purchasing power parity 

As I mentioned earlier, purchasing power parity works under the law of one price. Thus, for a bundle of goods, the partner country’s price must be equal to the domestic price after adjusting for the exchange rate. Mathematically, we can calculate it with the following formula:

Pd = Sd/f x Pf

Where:

• Pd = domestic price
• Pf = price abroad
• Sd/f = PPP exchange rate, domestic currency against foreign currencies

Take, for example, a product bundle in Indonesia and the United States. When we adjust it to the PPP exchange rate, the prices for both should be equal.

Assume you are Indonesian. For example, suppose the US’s price is USD1, and the rupiah exchange rate against the US dollar is IDR14,000/USD. So, for this product, the price in Indonesia should be IDR14,000 (USD1 x IDR14,000/USD).

Types of purchasing power parity

Two types of purchasing power parity:

• Absolute purchasing power parity
• Relative purchasing power parity

Under absolute purchasing power parity, we use the ratio of the two countries’ price levels to calculate the PPP exchange rate. Meanwhile, relative purchasing power parity uses the ratio of changes in price levels in the two countries. The formula is as follows:

In the previous example, you know that the United States and Indonesia prices are USD1 and IDR14,000, respectively. Thus, under absolute purchasing power parity, the rupiah exchange rate against the US dollar should be IDR14,000/USD1 = IDR14,000/USD.

Purchasing power parity by country

Following is the purchasing power parity data by country (units of local currency per international USD). I accessed it from the World Bank website as of 20 October 2020. 

Advantages and disadvantages of purchasing power parity

Purchasing power parity concept has several uses.

First, it makes comparisons of economic data between countries more relevant. GDP and GDP per capita data are two examples. So, you can use it to provide a more accurate picture of a country’s standard of living.

Second, the PPP exchange rate helps to determine trends in exchange rates over the long term. Market exchange rates tend to move towards the PPP exchange rate.

Third, the PPP exchange rate is more comparable, especially when a country’s government manipulates its exchange rate or when speculative attacks or carry trades occur. Both cause the market exchange rate to deviate from its long-run fundamentals or equilibrium.

Meanwhile, some of the criticisms against PPP are.

First, PPP does not consider differences in the quality of goods between countries. The same product, for example, can have a different quality in different countries. Thus, it is difficult for us to determine identical baskets of goods and services.

Consumer tastes and preferences also vary across countries. Often, manufacturers use a differentiation approach rather than product standardization. They adapt their offerings to local tastes in each country. And purchasing power parity does not capture such a difference.

Second, the assumption of the law of one price is unrealistic. Transportation costs and trade barriers exist in international trade. These two factors contribute to the costs of moving goods between markets located in different countries.

Third, PPP measurements are inaccurate. The number of goods flowing in the economy is enormous. Also, some items may only be available in certain countries and not in other countries. Survey data are also available at sparse intervals.