Purchasing Power Parity Definition | Formula and Example | BoyceWire
Purchasing Power Parity Definition

Purchasing Power Parity Definition

Purchasing Power Parity (PPP) Definition
Formula, Example, and Limitations

WRITTEN BY PAUL BOYCE | Updated 18 September 2020

What is Purchasing Power Parity (PPP)

Purchasing Power Parity is a measurement that is used to compare the spending power between two or more nations. This is done through a basket of commonly bought goods which measures the difference in price between two nations. For instance, a Big Mac in the US may cost $8, whilst it costs £5 in the UK. Purchasing Power Parity (PPP) calculates the exchange rate by which both countries would see ‘parity’. In other words, the PPP exchange rate would be 1.6 as that is the ratio between a Big Mac in the UK at £5 and the US at $8.

PPP measures the exchange rate by which two nations would achieve absolute parity in the number of goods they could buy. For example, many tourists will go away on cheap holidays knowing they can buy a meal at half the price they do at home. Hotels may be cheaper, food may be cheaper, and excursions may be cheaper. This is because there is not purchasing power parity between the two nations – meaning one currency is undervalued, and another overvalued.

Key Points
  1. PPP is a measured used to calculate how much it costs to buy a ‘basket of goods’ in one country compared to another.
  2. The PPP between two nation represents the equilibrium exchange rate. Anything above or below this would suggest the currency is over or undervalued.
  3. Using PPP allows us to compare living standards of countries.

PPP is based on three assumptions. First of all, there are no transaction costs. In other words, it doesn’t cost significantly more for goods to be shipped in or manufactured. Second of all, there are no trade barriers that would enhance the price of the basket of goods. And third of all, it ignores regional differences. For instance, you get less for your money in California than you do in Alabama.

In its very basic form, PPP calculates the average basket of goods in one country and compares to another in that local currency. The PPP is then calculated by converting the value in one currency, to the value in the other. So how much of Currency A is needed to buy exactly the same quantity of goods with Currency B.

How Purchasing Power Parity is Measured

Purchasing Power Parity takes a basket of commonly purchased goods such as milk and bread, among others. It then calculates the price of these, thereby working out the total cost of these goods in local currency.

The value of these basket of goods may cost 100 million Yuan in China but only 5 million US dollars in America. To calculate the PPP, we would divide the total Yuan by the total US dollars. In this case, it would equal 100 million Chinese Yuan divide by 5 million US dollars – which equals 20 Chinese Yuan to the US dollar.

At this rate, PPP is achieved as both nations can buy the same number of goods and services at this exchange rate. So if you earnt $5 in the US, you could exchange it and buy the same number of goods in China. However, if the market exchange rate is higher than the PPP, for instance, 25:1 – it would mean that the US dollar is stronger than the Chinese Yuan as it can buy more of its currency.

In this case, the US can buy more goods and services from China, because its exchange rate is stronger than what PPP theory would dictate. So if you earnt $5 in the US, you could exchange it and buy even more goods from China.

Purchasing Power Parity Formula

GDP Purchasing Power Parity

When comparing two nations’ GDP, it can be difficult to get an accurate picture using the market exchange rate. For instance, there may be two countries that produce exactly the same number of goods. However, due to currency manipulation and market speculation, the market exchange rate in Country A is 2.5 to the currency in Country B. When comparing the GDP of both countries, it may seem like Country A is superior as it takes 2.5 times as much currency from Country B for one in Country A.

What PPP does is eliminate the market influences and directly compares the true price of goods and services between nations. So if we look back on this example, both countries produce the same number of goods, so there would be Purchasing Power Parity – instead of an exchange rate of 2.5. This gives us a more accurate picture of the economic output when comparing nations.

Purchasing Power Parity Example

The newspaper ‘The Economist’ created a simplified example of the Purchasing Power Parity Index. Named ‘The Big Mac Index’, it simply works out the price in Country A and Country B, and calculates the PPP between the two countries.

For example, the 2020 index shows that a Big Mac costs £3.39 in Britain and US$5.71 in the United States – which shows a PPP exchange rate of 0.59. This is calculated by dividing the price in Britain (£3.39), by the price in the US ($5.71). At the same time, the actual exchange rate is 0.79 – which suggest the British Pound is undervalued by over 25 percent.

The Big Mac Index is a useful example as it is one of few items that is very similar in quality, but also, widely available across the world. At the same time, it is much easier to compare one item than a basket of thousands of goods. Yet whilst the Big Mac provides a rough indication of the PPP between two countries, it is not necessarily accurate for the very reason that it only considers one good. However, it does provide a good indication on the true value between currencies.

Limitations of Purchasing Power Parity

1. Availability and Demand for Goods

PPP uses a basket of goods between the two nations. However, not all goods from Country A may be available in Country B, and visa versa. This makes it difficult to compare between countries in the first place. We also have the fact that goods have different price elasticities and demand levels.

If we look at India, motorbikes are extremely popular because they are convenient for traveling in large cities. However, in the US, they are not so popular. At the same time, the bikes that sell in the US are big bikes such as Harley Davidsons – whilst smaller scooter types are more popular in India.

Goods that are in high demand in one country are likely to sell for a higher price – whilst goods that are in low demand will likely sell for less. So any major differences in demand between two nations can play an important part in skewing the ratio.

2. Consideration of Quality

PPP measures how much it costs to buy a basket of goods in two countries. However, the difference in the quality of a bottle of milk can differ between the US and Vietnam. The quality of clothing or electronics may also differ – so there is no fool-proof way of comparing two products in different countries.

The quality of goods in Sudan is not going to be of the same standard as the US. Two outcomes may result. First of all, the price of goods in Sudan may be cheaper to reflect the quality of the goods. As a result, the PPP would show a higher exchange ratio. For example, a burger in the US may cost $5 and in Sudan, it costs 100 Sudanese pounds. This would suggest a PPP exchange rate of 20:1. However, to get a similar quality burger, it may actually cost 200 Sudanese pounds, meaning the PPP rate is actually 40:1.

Without an accurate measure for quality, the rate by which purchasing power parity is achieved, is much lower. In this example, the PPP rate is 20:1, but when quality is considered, it is 40:1. So if the exchange rate is set at the original PPP (20:1), consumers would go over from the US and receive 20 Sudanese pounds for each $1. However, to get goods of the same quality, it will be twice as expensive because in reality, the PPP rate is 40:1.

What this does is artificially inflate the rate by which true purchasing power parity is achieved. In other words, the Sudanese pound would be artificially inflated because, in reality, people need to spend more to get the same quality of goods. However, the additional drawback is that the same quality may not even exist.

3. Lack of Accuracy

PPP is a huge undertaking that takes months and thousands of surveys. This means that the statistics are only available at infrequent intervals. In order to get this data, thousands of surveys have to go out to hundreds of nations and millions of companies. Through this statistical undertaking, prices are acquired and allocated to the basket of goods for each nation.

Methodological questions have been raised regarding the accuracy. For example, how accurate are the pricing figures achieved in countries such as Vietnam or Sudan? Furthermore, do they consider quality, and price differences between regions?

4. Types of Goods

When looking at the purchasing power between countries, there are two main types of goods. First of all, we have local, non-transferable goods. Examples include haircuts, cleaning services, and dentistry. These are more easily comparable, so the PPP ratio will be more effective in determining the true value of money between countries.

Second of all, we have tradable goods and non-perishable commodities. Examples include, coal, tinned goods, cars, and other capital equipment. These are more widely traded and therefore affect the countries exchange rate. At the same time, these types of goods are more likely to vary in price between nations. For instance, it is far cheaper to ship something from Mexico to the US, than it is to ship from Mexico to India.

These types of goods are more likely to be affected by the actual exchange rate, which brings PPP more in line with what the exchange rate is currently. For example, Country A and Country Z are trading partners. The exchange rate between them is 1:2. Country Z sells a car to Country A for Z-10,000 (its local currency). Country A must therefore pay A-5,000. So when comparing using PPP, those goods are already influenced by the existing exchange rate.

General FAQs on Purchasing Power Parity (PPP)

What is purchasing power parity in simple terms?

Purchasing Power Parity (PPP) is a measure that calculates the rate required to buy the same number of goods in one country compared to another.

Why is purchasing power parity important?

Purchasing Power Parity is important as it allows us to get a good comparison on how much $1 in the US can buy in India and other nations. It highlights where currencies are overvalued – whereby the currency in one country can buy more goods in another, or, when it’s undervalued.

How is purchasing power parity calculated?

Purchasing power parity is calculated by dividing the total value of goods in Country A, by the total value of goods in Country B.

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