What Is Purchasing Power Parity?

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So, PPP is a key factor in comparing the GDP of multiple countries. It considers a single price approach meaning all the goods will cost the same in the US dollar. The World Bank is the nodal agency for computing the PPP globally using the official exchange rate (OER).

Key Takeaways

  • Purchasing power parities is a theory or a tool used to determine the exchange rate of currencies while comparing the cost of living and wealth across nations worldwide. It is based on the law of one price (LoOP) but an aggregate price of identical products.The two types of PPP are – absolute parity and relative parity.PPP has many advantages, like remaining stable over the years and measuring a nation’s wealth, cost of living, and purchasing power easily without accounting for Gross Domestic Product.

Purchasing Power Parity Theory Explained

Purchasing power parity theory refers to a macroeconomic metric that economists use to compare the purchasing power of one country’s currency with that of other countries currencies. An idea in the sixteenth century’s school of Salamanca led to the concept of PPP. Later, Swedish economist Gustav Cassel developed this theory in 1916 in his book “The Present Situation of the Foreign Trade.” As per the purchasing power parity 2021 report by Worldometer, Qatar has the highest PPP of 752%.

Analysts and economists use this exchange rate to calculate and compare the prices of a basket of products of the same type in two countries. Using PPP helps one to find the lowest price of goods or services globally. Moreover, it allows a comparison of purchasing power of various currencies at equilibrium using exchange rates when the basket of products has the same cost in any two countries.

The theory of PPP assumes that trading goods and services across countries bring about major differences in their spot exchange rate. Moreover, it suggests that many transactions start affecting a country’s current account, leading to a change in the exchange rate related to that country’s foreign exchange. The law of one price (LoOP) forms the pillar of the PPP theory. However, economists apply it aggregately and with certain riders. For example, LoOP says that under nil taxes and transportation charges in any two markets, the cost of the same products is the same. 

As a result, countries with multi or free trade agreements have less parity in goods and services prices than those with fewer trade agreements. Moreover, PPP is the twisted version of LoOP, where economists apply a single price band as aggregate. The twist is that if LoOP holds for a small set of identical products, it must hold for all the same products in any two markets. As a result, PPP always relates between the country’s exchange rate and its price indices.

Types Of Purchasing Power Parity

In macroeconomic theory, one finds the following two different types of PPP: 

1. Absolute Parity

It means that a basket of identical products in one country will cost the same in another, irrespective of the country in which it is produced. However, it gets skewed and static in the absence of excluding inflation. 

2. Relative Parity

Relative purchasing power parity includes inflation while stating that the exchange rate equals the price levels of goods in the long term. Therefore, inflation will homogenize PPP making it equal to the exchange rate in the long term.

Purchasing Power Parity Formula

To calculate the PPP of a nation, one has to divide the cost of the goods of one currency by the cost of the goods of another benchmark currency. For example, the U.S. dollar. PPP has its basis on the fundamental that the same products get priced similarly in different countries. Hence, the purchasing power parity formula can get expressed as:

PPP exchange rate of currency A upon currency B = S

Cost of a basket of product 1 in country A = P1

Cost of a basket of product 2 in country B = P2

So, the PPP exchange rate of currencies –

S = Cost of the basket of product 1 in country A/ Cost of the basket of product 2 in country B 

S = P1/ P2

Economists use purchasing power parity calculators or software to calculate big figures easily.

Calculations 

Let us do some calculations related to PPP for a clearer understanding of purchasing power parity by country.

As per the 2020 index data-

Cost of a big mac in UK= £3

Cost of a big mac in the U.S. = $6

Therefore, the PPP exchange rate of the big mac= PPP = Cost of a basket of big mac 1 in country A/ Cost of the basket of big mac 2 in country B 

PPP exchange rate= £3/ $6= 3/6=0.50 

However, the actual exchange rate of big mac between the two countries is 0.80. Hence, one can say that the American dollar is overvalued by 25%.

Example

Let us use a purchasing power parity example to understand the concept better. 

Let us assume that the price of 1 hamburger in the USA is $5 per piece. On the contrary, the same burger costs 5.50 Yuan in China. So if a Chinese person C visits America and buys five hamburgers, C will get to pay 178 Yuan as $1 equals 7.12 (October 2022) Yuan. In other words, the Chinese would have to pay only 5*5.50 or 27.50 Yuan in China for five similar burgers. So it means that C used to pay only $5.50 to buy five hamburgers in China compared to $178 in the U.S. 

It means the Chinese currency Yuan, gets devalued compared to the US dollar. Therefore, it is called currency devaluation. So, as a result, one can say there is PPP between China and the U.S. economy.

Advantages Of Purchasing Power Parity

PPP is the oldest method of theoretical economics that aids the comparison of prices of the same products across different nations. Hence, there are many advantages of using the PPP as an economic parameter, as listed below:

  • If the goods or services do not cost the same in two countries, one currency gets undervalued more than the other.It helps determine market distortions arising out of government and inflation in a country.It is the best method to gauge the trade imbalances between two countries based on imbalanced PPP.The difference in PPP is a key indicator of differences in the standard of quality of life between the two countries.PPP is a good measurement tool to measure the wealth of any country. But unfortunately, GDP metrics can represent a nation’s wealth inaccurately. An economist could correct the trade imbalance between two countries by observing the differences between the country’s currency rate and PPP. As a result, only a little adjustment in the currency valuation could lead to a balance of trade differences.The most important advantage of PPP is that it has remained stable over the years.Moreover, PPP is the best measure of a nation’s overall economic health. This is because it considers all the non-traded goods across the nation.

This article has been a guide to What is Purchasing Power Parity. Here, we explain its types, formula with calculation, an example, and advantages. You can also go through our recommended articles on corporate finance –

Swedish economist named Professor Gustav Cassel gave the theory of PPP. He suggested that the purchasing power of two nations is determined using the exchange rate between any two nations that, in turn, depends on the comparative purchasing power of the respective countries currencies.

Economists use the purchasing power parity to compare one country’s economic growth and living standards with the other based on the basket of goods method.

As per the world bank group, one can compute the purchasing power parity exchange rate by:● Taking two varieties of rice or;● Using the geometric mean related to their price relatives.

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