An economic theory that the true rate of exchange between two currencies can be determined by what can be bought with a unit of each currency. Parity is achieved when what can be purchased is the same.
In economics, purchasing power parity (PPP) is the method of using the long-run equilibrium exchange rate of two currencies to equalize the currencies' purchasing power.
Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries' relative inflation rates and the change in the exchange rate of their currencies.
A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.
Market exchange rates fluctuate widely, but many believe that PPP exchange rates reflect the long run equilibrium value. The distortions caused by using market rates are accentuated because prices of non-traded goods and services are usually lower in poorer economies.
The differences between PPP and market exchange rates can be significant. However, based on nominal exchange rates, one US dollar is currently equal to 7.96 yuan.
When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
Explanation
For a US dollar to buy as much in the UK as in the US, as is assumed under the law of one price, the price of a basket of goods in pounds in the UK (denoted as: £P) times the spot exchange rate (denoted as: $/£) should equal the price of the same basket in the US priced in dollars (denoted as: $P).
£P ($/£)= $PThis implies that the exchange rate that equalizes the value of a dollar of purchasing power (the PPP exchange rate) is:
($/£)= $P/£PIf the actual spot rate is greater, it suggests that the £ is over-valued against the $.
For example if a "representative" consumption basket costs $1,500 in the US and £1,000 in the UK the PPP exchange rate would be $1.50/£.
Relative PPP
Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate.
,
where St is the spot rate in Foreign Currency/Domestic Currency and Pt is the price level in period t (foreign values are marked by an asterisk).
According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the USD should depreciate by 2% compared to the purchasing power of the EUR (equivalently the EUR will appreciate by about 2%)
PPP equalization and the law of one price
The law of one price states that differing prices of a traded good will tend to equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates.
The naïve PPP hypothesis is that free trade of goods should revert exchange rates to their PPP values.
Big Mac Index
An entertaining example of one measure of PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD 4 in the US and GBP 3 in Britain, the PPP exchange rate would be £3 for $4. Because of a difference in purchasing power within some of the regions using the CFA franc, their purchasing power parity exchange rate differed greatly (lower implies a stronger currency): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167.
GDP of China
The CIA misuses the purchase power parity (PPP) method in its calculations of Gross National Product .
Need for PPP adjustments to GDP
Using market exchange rates to compare countries' standard of living or per capita Gross Domestic Product can give a very misleading picture. The exchange rate only reflects traded goods in contrast to non-traded ones. However, this exchange rate results from international trade and financial markets. Measuring income in different countries using PPP exchange rates helps to avoid this problem.
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.
Difficulties
The main reasons why PPP does not perfectly reflect standards of living are
PPP numbers can vary with the specific basket of goods used, making it a rough estimate. International competitiveness is mainly affected by the exchange rate and not by PPP. Imported goods are purchased at market exchange rates, and thus a country that has to import all of its food would appear better off than it actually is if the PPP is used as the measurment of well-being.PPP calculations are often used to measure poverty rates.
Range and quality of goods
The goods that the currency has the "power" to purchase are a basket of goods of different types:
Local, non-tradable goods and services (like electric power) that are produced and sold domestically.The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate.
More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like China), as against high income countries (like Switzerland). (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. This is sometimes called exploitation.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid).
Difficulties with PPP comparisons in welfare economics
While using PPP exchange rates for income comparison is an improvement over using market exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. (This is not primarily a flaw in the exchange rate methodology, as cultural and interpersonal differences in utility functions are a more fundamental microeconomic problem.)
A PPP exchange rate varies depending on the choice of goods used for the index (CPI). Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another, see: consumer price index.
Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life.
For example, in 2002, the nominal GDP per capita in Japan was about US$40,000, while the equivalent PPP into a U.S. goods basket was estimated at $27,000.
Clarification to PPP Numbers of the IMF
The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that area's currency. The only time the PPP exchange rate and the market exchange rate can differ is when the GDP number is converted into another currency.
Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: . The PPP exchange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.
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