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What Is Purchasing Power Parity?

Purchasing Power Parity (PPP) is a macroeconomic theory that compares the currencies of different countries through a "basket of goods" approach. Within the realm of international finance and macroeconomics, PPP suggests that, in the absence of transaction costs and trade barriers, identical goods and services should cost the same in different countries when their prices are expressed in a common currency. This theory helps economists compare the standard of living and economic productivity between nations by adjusting for differences in price levels. The fundamental idea behind purchasing power parity is that a given amount of money should buy the same quantity of goods and services in any country.

History and Origin

The concept of purchasing power parity has roots that can be traced back to the 16th century, but it was popularized and formally developed by the Swedish economist Gustav Cassel in the early 20th century. Cassel extensively wrote on the determination of exchange rates during and after World War I. His work, particularly in 1918, led him to coin the term "purchasing power parity" as a way to explain how exchange rates should adjust to reflect the relative purchasing power of currencies amid significant inflation.¹², ¹³, ¹⁴ He proposed that given free movement of goods and substantial trade between two countries, the actual exchange rate would not deviate significantly from this purchasing power parity.¹¹ Cassel's contributions transformed the theory into a widely discussed paradigm within economic thought, serving as a tool for analyzing currency valuations and international monetary stability.¹⁰

Key Takeaways

• Purchasing Power Parity (PPP) posits that a identical basket of goods should cost the same in different countries when converted to a common currency.
• PPP is a theoretical economic equilibrium that helps compare the real output and well-being between nations, rather than just nominal values.
• It is used by organizations like the International Monetary Fund (IMF) and the OECD to make economic forecasts and policy recommendations.⁹
• Discrepancies between PPP and market exchange rates can indicate whether a currency is undervalued or overvalued.
• The theory has limitations, particularly concerning non-tradable goods and barriers to international trade.

Formula and Calculation

The absolute form of purchasing power parity is expressed by a simple formula:

Where:

• ( S ) = Exchange rate of currency 1 to currency 2 (units of currency 1 per unit of currency 2)
• ( P_1 ) = Cost of a "basket of goods" in country 1 (in currency 1)
• ( P_2 ) = Cost of the same "basket of goods" in country 2 (in currency 2)

This formula suggests the theoretical exchange rate at which the two currencies would be at parity. If the actual foreign exchange market rate deviates from this calculated PPP rate, it implies an over- or undervaluation of one of the currencies relative to the other.

Interpreting the Purchasing Power Parity

Interpreting purchasing power parity involves comparing the calculated PPP exchange rate with the prevailing market exchange rate. If the market exchange rate is higher than the PPP rate, the domestic currency is considered undervalued, meaning you get more foreign currency for your domestic currency than what purchasing power parity suggests. Conversely, if the market exchange rate is lower than the PPP rate, the domestic currency is considered overvalued. These interpretations provide insights into a country's currency valuation and the relative cost of living. While not a precise predictor of short-term exchange rates, PPP can offer a long-term perspective on currency trends and help analyze a nation's competitive position in global markets.

Hypothetical Example

Imagine a standard coffee machine costs $100 in the United States. In the Eurozone, the exact same coffee machine costs €90. To calculate the purchasing power parity exchange rate between the U.S. dollar and the Euro:

This PPP exchange rate suggests that, according to the cost of coffee machines, €1 should theoretically be equivalent to $1.11.

Now, let's say the current market exchange rate is $1.20 per €1.
Since the market rate ($1.20) is higher than the PPP rate ($1.11), it implies that the Euro is overvalued relative to the U.S. dollar, or conversely, the U.S. dollar is undervalued against the Euro based on this single good. An individual converting dollars to euros at the market rate would find the coffee machine cheaper in the U.S. if they were to convert their euros back to dollars and buy the machine there, suggesting a potential for arbitrage if transportation costs were negligible.

Practical Applications

Purchasing power parity serves several practical applications beyond theoretical academic discussions. Governments and international organizations frequently use PPP-adjusted figures when comparing countries' gross domestic product (GDP) to provide a more accurate picture of economic size and output, free from fluctuations in market exchange rates. This allows for better comparisons of economic growth and living standards across nations.

For instance, the International Monetary Fund (IMF) utilizes PPP rates in its economic analyses and projections, particularly when assessing the relative size of economies and the well-being of their populations. Additio⁸nally, the well-known Big Mac Index, published by The Economist, uses the price of a McDonald's Big Mac burger in various countries as a simplified and humorous way to illustrate purchasing power parity. While n⁶, ⁷ot a rigorous economic tool, it effectively demonstrates the concept of currency misalignment and relative consumer purchasing power. Busines⁵ses engaged in international operations may also consider PPP when making decisions about pricing, investment, and market entry, as it offers insights into the true cost of doing business in different regions.

Limitations and Criticisms

Despite its utility, purchasing power parity faces several limitations and criticisms. One significant challenge arises from the "basket of goods" itself. The assumption that an identical basket of goods and services exists and is consumed similarly across all countries is often unrealistic. Tastes, cultural preferences, and product availability vary widely, meaning a truly identical basket is rarely achievable. Differences in product quality, taxation, and subsidies also complicate comparisons.

Furthermore, PPP often struggles with the inclusion of non-tradable goods and services, such as haircuts or local transportation. These services are not subject to international trade and thus their prices are not equalized by arbitrage, leading to persistent price differentials across borders. Trade b³, ⁴arriers, tariffs, quotas, and transport costs also prevent the free flow of goods that would otherwise equalize prices under PPP theory. Economists have noted that while PPP may hold in the long run, short-term deviations can be substantial due to factors like capital flows and speculative activity in the foreign exchange market. A 1984 ²NBER Working Paper by Rudiger Dornbusch, for example, explores the empirical challenges and limitations of applying purchasing power parity in practice, particularly emphasizing the role of non-traded goods prices in deviations.

Pur¹chasing Power Parity vs. Market Exchange Rate

The distinction between purchasing power parity and the market exchange rate is crucial in international economics. The market exchange rate is the actual rate at which one currency can be exchanged for another in financial markets, determined by the forces of supply and demand, capital flows, monetary policy decisions, and speculative activity. It is highly volatile and reacts to immediate economic news, interest rate differentials, and investor sentiment.

In contrast, purchasing power parity represents a theoretical exchange rate that would equalize the purchasing power of two currencies, assuming a standardized basket of goods and services. While market exchange rates reflect financial transactions and trade balances, PPP focuses on the relative cost of living and the real purchasing power of income in different countries. Market rates are essential for daily transactions and capital movements, whereas PPP provides a long-term theoretical benchmark for currency valuation and is more relevant for comparing economic aggregates like gross domestic product (GDP) and assessing economic well-being across borders, abstracting from short-term market noise.

FAQs

How does purchasing power parity relate to inflation?

Purchasing power parity is closely linked to inflation. The relative PPP theory suggests that changes in exchange rates between two countries should reflect the difference in their inflation rates. If a country experiences higher inflation than another, its currency is expected to depreciate to maintain purchasing power parity. This concept implies that a currency's value erodes internally due to inflation, and the exchange rate adjusts to maintain external purchasing power.

Why is the Big Mac Index used to explain PPP?

The Big Mac Index is used because the Big Mac hamburger is a relatively standardized product sold in thousands of McDonald's restaurants worldwide. This makes it a simple, informal, and easily understandable "basket of goods" to compare prices across different countries. While not scientifically rigorous, it provides a quick, illustrative snapshot of purchasing power parity and highlights currency overvaluation or undervaluation in an accessible way.

Is PPP a good predictor of short-term exchange rates?

No, purchasing power parity is generally not considered a good predictor of short-term exchange rates. Market exchange rates are influenced by many factors, including interest rates, capital flows, speculative trading, and political events, which can cause significant short-term deviations from PPP. PPP is more of a long-term economic theory, suggesting that exchange rates should eventually converge to a level that equalizes purchasing power, but this convergence can take many years.

How is PPP different from the Consumer Price Index (CPI)?

While both relate to prices, purchasing power parity (PPP) compares the prices of a basket of goods between different countries to derive a theoretical exchange rate. The Consumer Price Index (CPI), on the other hand, measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services within a single country. CPI is primarily used to measure domestic inflation, whereas PPP is used for international comparisons of purchasing power and economic output.

Why do economists use PPP for GDP comparisons?

Economists use purchasing power parity for gross domestic product (GDP) comparisons because using market exchange rates can distort the true relative sizes of economies. Market exchange rates often undervalue the purchasing power in developing countries where many goods and services, particularly non-tradable goods, are significantly cheaper than in developed nations. By adjusting GDP using PPP, a more accurate comparison of the real volume of goods and services produced and consumed in different economies can be achieved, providing a better measure of overall economic output and relative standard of living.