What is Purchasing Power Parity (PPP)?
The concept of Purchasing Power Parity (PPP) is used to make multilateral comparisons between the national incomes and living standards of different countries. Purchasing power is measured by the price of a specified basket of goods and services. Thus, parity between two countries implies that a unit of currency in one country will buy the same basket of goods and services in the other, taking into consideration price levels in both countries.
A PPP ratio measures deviation from the condition of parity between two countries and represents the total number of the baskets of goods and services that a single unit of a country’s currency can buy.
Origin of Purchasing Power Parity
The concept originated in the 16th century and was developed by Swedish economist, Gustav Cassel, in 1918. The concept is based on the “law of one price,” which states that similar goods will cost the same in different markets when the prices are expressed in the same currency (assuming the absence of transaction costs or trade barriers).
Purchasing Power Parity and Exchange Rates
One may argue that the market exchange rate can be a measure of deviation from PPP. However, the exchange rate between two countries typically is determined by the supply and demand forces of the traded goods, services, and assets; the prices of non-traded goods are not taken into consideration, which leads to inaccuracy while comparing living standards. An example will make this clearer. Let the US dollar be equivalent to 60 Indian rupees (1$ = ₹60). An American visits India and goes to the market. She buys 10 cupcakes with ₹120 and remarks, “Cupcakes are cheaper here!” In the US, she buys 10 similar cupcakes for $3. Now, $3 = ₹180, which means 15 cupcakes in India! So, the PPP ratio of the exchange for cupcakes is $3 = ₹120, that is, $1 = ₹40.
However, since cupcakes are not traded, the market exchange rate does not incorporate the fact that they are “cheaper” in India. Likewise, all non-traded goods are not represented in the market exchange rate in the two countries. As in this case, it is generally seen that the official exchange rate will understate the living standards of developing countries. This is because developing countries tend to achieve factors of production, i.e., unit labor costs are generally lower, which results in the non-traded goods being mostly cheaper (the Balassa-Samuelson effect, among others, provides a different explanation regarding the price differential between traded and non-traded goods). As a country develops, it is generally believed that more goods will be traded and that the gap between the PPP exchange rate and the market exchange rate will diminish.
PPP ratios help in making more meaningful comparisons of living standards in different countries.
Uses of Purchasing Power Parity
Large differences in inflation rates across the globe make it impossible to accurately compare and measure the relative outputs of economies and their living standards. PPP-based variables are in real terms, thus allowing comparison. The following diagram shows the difference between GDP measured in nominal terms and PPP-based GDP, based on the latest estimates.
PPPs play a vital role and are preferred in the analyses carried out by policymakers, researchers, and private institutions, as they do not show major fluctuations in the short run. In the long run, PPPs somewhat indicate in which direction the exchange rate is expected to move as the economy develops further.
Constructing Purchasing Power Parity
The general method of constructing a PPP ratio is to take a comparable basket of goods and services consumed by the average citizen in both countries and take a weighted average of the prices in both countries (the weights representing the share of expenditure on each item in total expenditure). The ratio of the prices will be the PPP rate of exchange.
Indexes such as the Big Mac Index and KFC Index use the prices of a Big Mac burger and a bucket of 12-15 pieces of chicken, respectively, to compare living standards between countries. These are moderately standardized products that include input costs from a wide range of sectors in the local economy, which makes them suitable for comparison.
Reliability of Purchasing Power Parity
Although it is widely used, PPP ratios may not always portray the real standard of living in countries, for the following reasons:
- The underlying expenditure and price levels that represent consumption patterns may not be reported correctly.
- It is difficult to construct identical baskets of goods and services while comparing dissimilar countries, as people show different tastes and preferences, and the quality of the items vary.
- The prices of traded goods are rarely seen to be equal, as there are trade restrictions and other barriers to trade which result in deviation from PPP.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To continue learning and advance your career, see the following free CFI resources: