Purchasing power parity

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a "basket of goods" approach. According to this concept, two currencies are in equilibrium or at par when a basket of goods is priced the same in both countries, taking into account the exchange rates.

Definition

Purchasing power parity is a method used to calculate the relative value of different currencies. It is based on the law of one price, which states that in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in terms of the same currency.

Calculation

The calculation of purchasing power parity involves the use of a price index, which is a measure of the average price of a basket of goods in one country compared to another. The most commonly used price index for PPP calculations is the Consumer Price Index (CPI).

Uses

Purchasing power parity is used for several purposes:

• To compare the Gross Domestic Product (GDP) of different countries. GDP at PPP takes into account the relative cost of local goods, services and inflation rates of the country, rather than using international market exchange rates which may distort the real differences in per capita income.
• To compare the living standards between countries. PPP eliminates the differences in price levels between countries, thus providing a more accurate measure of the standard of living.
• To determine the relative value of different currencies.

Criticisms

Despite its widespread use, PPP has been criticized for several reasons:

• It assumes that the basket of goods used is the same in all countries, which is not always the case.
• It does not take into account the differences in quality of goods and services between countries.
• It assumes that there are no transportation costs or trade barriers, which is not always the case.

See also

• Big Mac Index
• International Comparison Program
• World Bank