A popular macroeconomic analysis measure for comparing economic productivity and living standards across countries is purchasing power parity (PPP). PPP is an economic theory that compares the currencies of different countries through a “basket of goods” approach, not to be confused with the Paycheck Protection Program created by the CARES Act.
According to this concept, two currencies are in equilibrium – that is, the currencies are at par – when a basket of goods has the same price in both countries, given exchange rates.
Key points to remember
- Purchasing Power Parity (PPP) is a popular measure used by macroeconomic analysts that compares currencies of different countries through a “basket of goods” approach.
- Purchasing power parity (PPP) allows economists to compare economic productivity and living standards between countries.
- Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
Click play to learn how to calculate purchasing power parity
Calculation of purchasing power parity
The relative version of PPP is calculated with the following formula:
S=P2P1or:S= Currency exchange rate 1 at the change 2P1= Cost of the property X in currency 1Inasmuch as
Comparison of Purchasing Power Parities of Nations
To make a meaningful price comparison between countries, a wide range of goods and services must be considered. However, this individual comparison is difficult to achieve due to the amount of data to be collected and the complexity of the comparisons to be made. To help facilitate this comparison, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP) in 1968.Inasmuch asInasmuch as
With this program, the PPPs generated by the ICP are based on a global price survey that compares the prices of hundreds of different goods and services. The program helps international macroeconomists estimate global productivity and growth.Inasmuch asInasmuch as
Every few years, the World Bank releases a report that compares the productivity and growth of various countries in terms of PPP and US dollars.Inasmuch asThe International Monetary Fund (IMF) and the Organization for Economic Co-operation and Development (OECD) both use weights based on PPP parameters to make forecasts and recommend economic policies.Inasmuch asRecommended economic policies can have an immediate short-term impact on financial markets.
Also, some forex traders use PPP to find potentially overvalued or undervalued currencies. Investors who hold stocks or bonds of foreign companies can use the PPP figures from the survey to predict the impact of exchange rate fluctuations on a country’s economy, and therefore the impact on their investment.
Associate purchasing power parity and gross domestic product
In contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of goods and services produced in a country. Nominal GDP calculates monetary value in current and absolute terms. Real GDP adjusts nominal gross domestic product for inflation.
However, some calculations go even further, by adjusting the GDP according to the PPP value. This adjustment attempts to convert nominal GDP into a number that is more easily comparable between countries with different currencies.
To better understand how the GDP associated with purchasing power parity works, suppose it costs $10 to buy a shirt in the United States and it costs €8.00 to buy an identical shirt in Germany . To do an apples to apples comparison, we first need to convert the €8.00 to US dollars. If the exchange rate were such that the shirt in Germany costs $15.00, then the PPP would be 15/10, or 1.5.
In other words, for every $1.00 spent on the shirt in the United States, it takes $1.50 to get the same shirt in Germany by buying it with the euro.
GDP by purchasing power parity vs nominal GDP
Disadvantages of Purchasing Power Parity
Since 1986, The Economist has playfully tracked the price of McDonald’s Corp’s Big Mac hamburger. (MCD) in many countries. Their study leads to the famous “Big Mac Index”. In “Burgernomics” – a landmark 2003 paper that explores the Big Mac Index and PPP – authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why purchasing power parity theory does not reflect reality well.Inasmuch asInasmuch as
Goods that are not available locally must be imported, which incurs transportation costs. These costs include not only fuel, but also import duties. Imported goods will therefore sell for a relatively higher price than identical goods of local origin.Inasmuch asInasmuch as
Government sales taxes such as Value Added Tax (VAT) can drive up prices in one country over another.Inasmuch asInasmuch as
Customs duties can significantly increase the price of imported goods, while the same goods in other countries will be comparatively cheaper.Inasmuch asInasmuch as
The price of the Big Mac takes into account the costs of inputs that are not traded. These factors include things like insurance, utility costs, and labor costs. Therefore, these expenditures are unlikely to be on par internationally.Inasmuch asInasmuch as
Goods may deliberately be more expensive in one country. In some cases, higher prices are due to the fact that a company may have a competitive advantage over other sellers. The firm may have a monopoly or be part of a cartel of firms that manipulate prices by keeping them artificially high.Inasmuch asInasmuch as
Although it is not a perfect measurement indicator, purchasing power parity offers the possibility of comparing prices between countries that have different currencies.