Purchasing Power Parity (PPP) Definition
Formula, Example, and Limitations
WRITTEN BY PAUL BOYCE | Updated 7 February 2022
What is Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is a measurement that economists use 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 example, a Big Mac in the US may cost $8 and £5 in the UK. Purchasing Power Parity (PPP) calculates the exchange rate by which both countries would see ‘parity’. In other words, the Purchasing Power Parity (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.
Purchasing Power Parity 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 are cheaper, food is cheaper, and excursions are cheaper. This is because there is not purchasing power parity between the two nations – meaning one currency is undervalued, and another overvalued.
- Purchasing Power Parity (PPP) is a measure that economists use to calculate how much it costs to buy a ‘basket of goods’ in one country in comparsion to another.
- The Purchasing Power Parity (PPP) between two nation represents the equilibrium exchange rate. Anything above or below this would suggest the currency is over or undervalued.
- Using Purchasing Power Parity (PPP) allows us to compare living standards of countries.
There are three main assumptions which define Purchasing Power Parity (PPP). First of all, there are no transaction costs. In other words, it doesn’t cost businesses significantly more to ship or manufacture goods. 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 example, you get less for your money in California than you do in Alabama.
In its very basic form, Purchasing Power Parity (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.
Example of Purchasing Power Parity
The newspaper ‘The Economist’ created a simple example of the Purchasing Power Parity Index. Named ‘The Big Mac Index’, it simply works out the price of a Big Mac 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 was 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 reasonable indication on the true value between currencies.
Purchasing Power Parity Formula
Purchasing Power Parity (PPP) takes a basket of commonly purchased goods such as milk, televisions, motor vehicles, and phones, among others. It then calculates the price of these, thereby working out the total cost of these goods in local currency.
The total value of these 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 the PPP would dictate. So if a consumer earns $5 in the US, they could exchange it and buy even more goods from China. This is one of the core driving factors in driving businesses to China where costs are comparatively lower.
Types of Purchasing Power Parity
In economic theory, there are two types of purchasing power parity:
Absolute Purchasing Power Parity
Absolute parity is the core theory of PPP. It is the theory that a basket of goods in one country is worth exactly that in another. As long as the product is similar, it doesn’t matter which country produces it, the price will remain the same. In other words, consumers in the US can buy exactly the same number of Big Mac’s as those in Germany.
To put it another way, absolute parity is where the exchange rate is equal to the ratio between prices in two countries. For example, a meal at KFC in the US may cost $10, whilst in the UK it costs £5. So the absolute parity would be where money in either country can be exchanged for an equal number of goods.
The main issue with absolute parity is that it doesn’t consider other factors such as inflation. It’s not very dynamic and is a static form of measurement.
Relative Purchasing Power Parity
By contrast to absolute parity, relative parity includes everything stated in absolute parity, but considers inflation. It is an economic theory that states exchange rates and price levels will equal each other over the long-term. That means that fluctuations due to factors such as inflation will bring the actual exchange rate out of PPP alignment. However, over the long-term, the exchange rate will equal PPP.
For example, an iPhone may cost $999 in the US and £799 in the UK. That would state that the PPP would be $999 / £799 = 1.25. However, the rate of inflation may increase the cost in the US to $1,099. This would bring it out of line with the PPP exchange rate of 1.25.
In the long-term, inflation in both the US and UK is likely to fluctuate. Relative parity would suggest that these fluctuations will even out over the course of many years, and bring it in line with PPP over a set period of time.
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.
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)
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.
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.
Purchasing power parity is calculated by dividing the total value of goods in Country A, by the total value of goods in Country B.