An Overview of Purchasing Power Parity (PPP)

What is the rate of growth of the global economy? 

Is China a bigger contributor to global growth than the US? 

Where does the typical individual have a better chance? 

 

These are the kinds of topics that economists and others are interested in, and at first glance, it seems logical to think that each has a simple answer. The truth, as with so many things in economics, is quite different.

 

To answer the questions, one must compare the output values of various nations. However, each country's statistics are reported in its own currency. 

 

This implies that each country's statistics must be transformed into a common currency before they can be compared. However, there are various approaches to this conversion, each of which might provide a very different result.

 

 

What is Purchasing Power Parity?

 

The purchasing power parity calculation tells you how much things would cost if all countries using the same currency. In other words, it is the rate at which one currency would need to be exchanged to have the same purchasing power as another currency. Purchasing power parity is based on an economic theory that states the prices of goods and services should equalize among countries over time.

 

Parity is tedious to compute. A U.S. dollar value must be assigned to everything. That includes items not widely available in America. For example, there aren't too many ox carts in the United States. Also, it is doubtful that the cart's U.S. price would accurately describe its value in rural Vietnam, where it's needed to grow rice.

 

PPP is calculated by the World Bank for each country in the world. It includes a map that illustrates the PPP ratio in comparison to the US.

 

The PPP is calculated using a multiple of the official exchange rate (OER) metric in many developing nations. The OER and PPP measurements are more comparable in developed nations since their living standards are closer to those of the United States. (Here)

 

Types of PPP

 

The economic theory is often broken down into two main concepts:

 

1. Absolute parity

 

The underlying PPP idea is absolute purchasing power parity (APPP), which argues that once two currencies are exchanged, a basket of commodities should have the same value. The hypothesis is usually based on the conversion of other international currencies into US dollars.

 

For example, if a can of Coca-Cola costs $1.50 in the United States, APPP suggests that a can of Coca-Cola in any other nation should cost $1.50 after conversion to the local currency.

 

If this is not the case, APPP indicates that the currency exchange rate will fluctuate over time until the items are of similar value – since there should be an equilibrium in the price of goods in the absence of trade barriers. This is a price-level theory that exclusively considers the same basket of items in each nation, with no other considerations.

 

The hypothesis, however, ignores inflation and consumer spending, as well as transportation costs and customs, all of which can influence the short-term exchange rate. The strength of a currency is inadequately reflected without these features.

 

2. Relative parity

 

The second notion, relative purchasing power parity (RPPP), is an extension of APPP that may be used in conjunction with the first. RPPP argues that there is a link between price inflation and currency exchange rates, despite the fact that it maintains that the value of the same items in various nations should equalise over time. 

 

It considers how much of an item or service one unit of money can purchase, which might fluctuate over time as inflation rates vary. According to the principle, inflation reduces a currency's actual buying power, hence inflation must be taken into account when adjusting the PPP. 

 

For example, if the UK had an annual inflation rate of 2%, then one unit of pound sterling would be able to purchase 2% less per year.

 

When we include this notion into APPP, we can observe that inflation rates account for a portion of the shift in currency power. Assume that the United Kingdom has a 2% inflation rate and Brazil has a 5% inflation rate. This indicates that the price of a basket of products in Brazil has risen by 5% in a year, whereas the price of the same basket of goods in the UK has only risen by 2%.

 

(Suggested blog: What is Balance of Payments and how is it affected?)

 

How to calculate purchasing power parity?

 

As I previously stated, buying power parity is based on the law of one price. As a result, after adjusting for the exchange rate, the price in the partner nation must be equivalent to the domestic price for a bundle of goods. We may compute it mathematically using 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 a product package in Indonesia and the United States, for example. The pricing for both should be similar when adjusted to the PPP exchange rate.

 

Assume you're a native of Indonesia. Assume the price in the United States is $1 and the rupiah exchange rate against the dollar is IDR14,000/USD. As a result, the pricing in Indonesia for this product should be IDR14,000 (USD1 x IDR14,000/USD).

 

(Related blog: Production Possibility Curve:-Assumptions and Features)

 

Importance of PPP

An idea is known as "the law of one price" lies at the heart of PPP. This is an economic assumption based on the idea that, given all other factors being equal, the same items in a worldwide market should be priced the same. The law of one price is based on the idea that market pricing would eventually push commodities of equal quality and value to customers to equilibrium. 

 

For a variety of reasons, this assumption isn't totally secure. Barriers to trade, transportation costs, tariffs, and the inability to import and export specific services can all have an impact on purchasing power parity.

 

Purchasing power parity is critical for creating relatively reliable economic data that can be used to compare market conditions across nations.

 

Purchasing power parity, for example, is frequently used to equalise gross domestic product figures. Because purchasing power varies by nation, the GDP number based on purchasing power parity is frequently different from nominal GDP, which is defined solely by currency exchange.

 

Advantages of Purchasing Power Parity

 

The following are some of the benefits of utilising PPP to compare the economies of various nations.

 

• In comparison to the market, PPP exchange rates are steady. When compared to financial world market prices, PPP exchange rates are very stable. Even when individual countries' markets are stable, comparing GDP using market rates might result in higher volatility in comparisons.

 

• It takes into consideration non-traded items. GDP is a metric that evaluates a country's economic production in terms of tangible, internationally traded items. PPP, on the other hand, takes into account the cost of non-traded products and services, such as haircuts and massages, and so reflects an economy's productivity.

 

• It gives instances of real-world living costs and standards. Every year, The Economist publishes the Big Mac Index, which compares the prices of a McDonald's Big Mac in 55 countries across the world. 

 

This PPP example employs a recognisable item as a point of comparison between global living expenses, which is comparable to the ICP's study. People on the street may check the PPP of various commodities in various locations to get an idea of how expensive or inexpensive their present home economy is. (Here)

 

Conclusion

 

In emerging markets and developing nations, there is a significant difference between market and PPP-based rates, with most of them having a market to PPP U.S. dollar exchange rate ratio of 2 to 4. The market and PPP rates, on the other hand, tend to be closer in industrialised nations. 

 

As a result, developing nations receive far more weight in aggregations based on PPP exchange rates than they do in aggregations based on market exchange rates. PPP exchange rates give China and India significantly higher weights in the global economy than market-based weights.

 

As a result, the weights used in global growth calculations make a large impact, but they don't make a big difference in estimates of aggregate growth in advanced economies. 

 

Under PPP exchange rates, the per capita income difference between the richest and poorest nations narrows slightly (though it remains considerable), and certain countries move up or down the income scale depending on the exchange rate conversion utilised.

(Must read: Comparing Money and Barter System)