In economics, purchasing power parity (PPP) is a method used to calculate an alternative exchange rate between the currencies of two countries. The PPP measures how much a currency can buy in terms of an international measure (usually dollars), since goods and services have different prices in some countries than in others.
PPP exchange rates are used in international comparisons of standard of living. A country's GDP is originally tallied in its local currency, so any comparison between two countries requires converting currency. Comparisons using real exchange rates are considered unrealistic, since they do not reflect price differences between the countries. The differences between PPP and real exchange rates can be significant. For example, GDP per capita in Mexico is ca. 6,100 U.S. Dollars, while on a PPP basis, it is 9,000$ (U.S. GDP/capita is 37,388$, as of 2004).
PPP is a theoretical exchange rate derived from the perceived parity of purchasing power of a currency in relation to another currency. It takes into account that some goods like real estate, services (e.g. medical services) and heavy items are non-traded , and thus not reflected in the exchange rate. In contrast to the "real" exchange rate that the currencies are traded for in the official market (as opposed to the black market), the PPP exchange rate is calculated from the relative value of a currency based on the amount of a "basket" of goods the currency will buy in its nation of usage. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy. The most common PPP exchange rate comes from comparing goods in a GDP reporting area with equivalent goods in the United States and through that come up with a PPP US dollar exchange rate. When GDP numbers from reporting regions are converted through this PPP exchange rate it's considered to be a better comparison of standard of living.
The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.
A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US and GBP£3 in Britain, the PPP exchange rate would be £3 for $4. In the same way, if a Big Mac or any basket of goods costs USD$4 in the US, the PPP exchange rate is always $4 for $4.
Relative PPP is concerned with change of price levels over different periods, also known as inflation rate. The equation looks like , whereby St is the spot_rate and Pt is the price in period t (Foreign values are marked by an asterisk). The change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European union rise by 1% the PPP of the USD has to depreciate by 2% compared to the PPP of the EUR (or alternatively the EUR will appreciate by 2%).
PPP equalization and the law of one price
The law of one price states that prices of traded goods will equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates.
The na´ve PPP hypothesis is that free trade of goods should revert exchange rates to their PPP values. However, econometric analysis rejects this hypothesis, and gives a better prediction of the PPP/exchange rate relationship (the CPI) based on relative GDPs. Neo-classical economics includes Balassa-Samuelson effect theory, which explains the PPP model adjustment giving the equilibrium CPI.
For more discussion, see Discussion and clarification of PPP.
A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to express these numbers in the same currency. Using actual exchange rates when making these comparisons can give a very misleading picture of living standards. The PPP method is used to as an alternative.
For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are any poorer; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.
West and Central African Franc
During 2003 the US Dollar bought on average about 550 CFA franc. Because of a difference in the perceived "purchasing power parity" within some of the regions using the CFA franc, their purchasing power parity exchange rate differed like this (lower is stronger parity): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167.
GDP of China
The CIA uses the purchase power parity method in its calculations of Gross National Product . By this measure the People's Republic of China has the second largest economy in the world, $6.449 trillion (2004 est.) (CIA methodology for PPP).
PPP: clarification and discussion
Main article: Discussion and clarification of PPP
The main reasons why PPP does not perfectly reflect standards of living are
- PPP numbers can vary with the specific basket of goods used, making it a rough estimate
- Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
- International competitiveness is mainly affected by the exchange rate, not PPP
- Differences in quality of goods are not sufficiently reflected in PPP.
Last updated: 10-26-2005 13:35:43