Formula to Calculate Purchasing Power Parity (PPP)

The “purchasing power parity” is a term used to explain the economic theory that states the exchange rate of two currencies will be in equilibrium or at par with the ratio of their respective purchasing powers. The formula for purchasing power parity of country 1 w.r.t. country 2 can be derived by dividing the cost of a particular good basket (e.g., good X) in country 1 in currency 1 by the cost of the same good in country 2 in currency 2.

A popular practice is to calculate the purchasing power parity of a country w.r.t. the U.S. We can also modify the formula by dividing the cost of good X in currency 1 by the cost of the same good in the U.S. dollars.

Purchasing Power Parity = Cost of good X in currency 1 / Cost of good X in U.S. dollar

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Calculation of Purchasing Power Parity (Step-by-Step)

Examples

Example #1

Let us take the example of purchasing power parity between India and the U.S. Suppose an American visits a particular market in India. The visitor bought 25 cupcakes for ₹250 and noticed that cupcakes are quite cheaper in India. The visitor claimed that, on average, 25 such cupcakes cost $6. Calculate the purchasing power parity between the two countries based on the given information.

  • Firstly, try to identify a good basket or commodity which is easily available in both the countries under consideration. Next, determine the cost of the good basket in the first country in its currency. The price will be reflective of the cost of living in the country. Next, analyze the cost of the good basket in the other country in its currency. Finally, we can compute the PPP formula of country 1 w.r.t country 2 by dividing the cost of the good basket in country 1 in currency 1 by the cost of the same good in country 2 in currency 2, as shown below. Purchasing Power Parity = Cost of good X in currency 1 / Cost of good X in currency

Purchasing Power Parity = Cost of good X in currency 1 / Cost of good X in currency

Given the cost of 25 cupcakes in INR = ₹250

Cost of 25 cupcakes in USD = $6, we can calculate the purchasing power parity of India w.r.t U.S.:

Purchasing power parity = Cost of 25 cupcakes in INR / Cost of 25 cupcakes in USD

= ₹250 / $6

Calculation of purchasing power parity of India w.r.t U.S. will be:

Purchasing Power Parity of India w.r.t U.S. = ₹41.67 per dollar.

Therefore, the purchasing power parity ratio of the exchange for cupcakes is USD1 = INR 41.67.

Example #2

Take another example to compute purchasing power parity between China and the U.S. In January 2018, a McDonald’s Big Mac cost $5.28 in the U.S., while the same Big Mac could be bought for $3.17 in China during the same period. Calculate the purchasing power parity between the two countries based on the given information.

[Exchange rate $1 = CNY6.76]

  • Given, Cost of Big Mac in CNY = 3.17 * CNY6.76 = CNY21.43Cost of Big Mac in USD = $5.28

The below table shows data for the calculation of purchasing power parity between China and the U.S.:

The calculation of the cost of Big Mac in CNY will be:

Cost of Big Mac in CNY = 3.17 * CNY 6.76 = CNY 21.43

Therefore, the purchasing power parity of China w.r.t U.S. can be calculated as:

Purchasing Power Parity = Cost of Big Mac in CNY / Cost of Big Mac in USD

= CNY 21.43 / $5.28

Calculation of purchasing power parity of China w.r.t US will be:

Purchasing Power Parity = CNY4.06 per dollar

Therefore, the purchasing power parity ratio of the exchange for Big Mac is USD1 = CNY4.06.

Purchasing Power Parity Calculator

You can use these purchasing power parity calculator.

Relevance and Uses

It is very important to understand the concept of the PPP formula because it is required to compare the national incomesNational IncomesThe national income formula calculates the value of total items manufactured in-country by its residents and income received by its residents by adding together consumption, government expenditure, investments made within the country and its net exports.read more and the standard of living of various nations. Hence, the metric of purchasing power parity between two countries represents the total number of goods and services that a single unit of one country’s currency will purchase in another country, considering the price levels in both countries. Therefore, when the theory of purchasing power parity holds good, this metric should be equal to unity.

Another major application of the purchasing power parity is calculation of the gross domestic productCalculation Of The Gross Domestic ProductGDP or gross domestic product refers to the sum of the total monetary value of all finished goods and services produced within the border limits of any country. GDP determines the economic health of a nation. GDP = C + I + G + NXread more as it helps offset the impact of inflation and other similar factors. The metric mitigates the problem of the large difference in inflation rates across countries and aids in the measurement of the relative outputs of various economies and their living standards. The variables based on purchasing power parity show the real picture, thus allowing comparison. The purchasing power parity method plays a significant role and is preferred in the analyses carried out by researchers, policymakers, and other private institutions. The variables based on purchasing power parity do not show major fluctuations in the short runShort RunA Short Run in economics refers to a manufacturing planning period in which a business tries to meet the market demand by keeping one or more production inputs fixed while changing others.read more. However, in the long run, the metric exhibits some variation, which indicates the direction of movement of the exchange rate.

This article is a guide to the Purchasing Power Parity Formula (PPP). We discuss purchasing power parity calculation using the PPP formula, examples, and templates. You may know more about financial analysis from the following articles:  –

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