Purchasing power parity PPP is a theory that measures prices of different areas using a common good or goods to contrast the real purchasing power between different currencies.

In that case, PPP produces an exchange rate that equals the price of the basket of goods at one location over the price of the basket of goods at a different location. The PPP exchange rate may be different from the market exchange rate because of transportation costs, tariffs, and other frictions.

Purchasing power parity is an economic theory for measuring prices at different locations. It is based on the Law of One Price , which says that, if there are no transaction costs nor trade barriers for a particular good, then the price for that good should be the same at every location.

Obviously, there are transportation costs, tariffs, and other frictions that prevent trading and purchasing of various goods. So, measuring a single good might cause a large error. PPP theory accounts for this by using a "basket of goods", that is, many goods with different quantities. PPP then computes an exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location.

The name "purchasing power parity" comes from the idea that, with the right exchange rate, consumers in every location will have the same purchasing power.

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the Law of One Price.

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So, ones traded easily and are commonly available in both locations. Different organizations that compute PPP exchange rates use different baskets of goods and can come up with different values. The PPP exchange rate may not match the market exchange rate. The market rate is more volatile because it reacts to changes in demand at each location.

Also, tariffs and difference in the price of labor see Balassa—Samuelson theorem can contribute to longer term differences between the two rates.

One use of PPP is to predict longer term exchange rates. Because PPP exchange rates are more stable and are less affected by tariffs, they are used for many international comparisons, such as comparing countries' GDPs or other national income statistics. These numbers often come with the label "PPP-adjusted". There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.

There are variations to calculating PPP. Szulc uses the geometric mean of the exchange rates computed for individual goods. While these methods work for 2 countries, the exchange rates may be inconsistent if applied to 3 countries, so further adjustment may be necessary so that the rate from currency A to B times the rate from B to C equals the rate from A to C.

Relative PPP is a weaker statement based on the Law of One Price , covering changes in the exchange rate and inflation rates. It seems to mirror the exchange rate closer than PPP does. Purchasing power parity exchange rate is used when comparing national production and consumption and other places where the prices of non-traded goods are considered important.

Market exchange rates are used for individual goods that are traded. PPP rates are more stable over time and can be used when that attribute is important. PPP exchange rates help costing but exclude profits and above all do not consider the different quality of goods among countries. The same product, for instance, can have a different level of quality and even safety in different countries, and may be subject to different taxes and transport costs.

Since market exchange rates fluctuate substantially, when the GDP of one country measured in its own currency is converted to the other country's currency using market exchange rates, one country might be inferred to have higher real GDP than the other country in one year but lower in the other; both of these inferences would fail to reflect the reality of their relative levels of production.

But if one country's GDP is converted into the other country's currency using PPP exchange rates instead of observed market exchange rates, the false inference will not occur.

The Purchasing Power Parity Theory of determination of Exchange Rates

Essentially GDP measured at PPP controls for the different costs of living and price levels, usually relative to the United States dollar, enabling a more accurate estimate of a nation's level of production. The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use.

Also, currencies are traded for purposes other than trade in goods and services, e.

Also, different interest rates , speculation , hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the associated Penn effect reflects such a systematic bias in using exchange rates to outputs among countries.

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For example, if the value of the Mexican peso falls by half compared to the US dollar , the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals.

Measuring income in different countries using PPP exchange rates helps to avoid this problem. PPP exchange rates are also valued because market exchange rates tend to move in their general direction, over a period of years. There is some value to knowing in which direction the exchange rate is more likely to shift over the long run.

In neoclassical economic theory , the purchasing power parity theory assumes that the exchange rate between two currencies actually observed in the foreign exchange market is the one that is used in the purchasing power parity comparisons, so that the same amount of goods could actually be purchased in either currency with the same beginning amount of funds.

What is Absolute Purchasing Power Parity?

Depending on the particular theory, purchasing power parity is assumed to hold either in the long run or, more strongly, in the short run. Theories that invoke purchasing power parity assume that in some circumstances a fall in either currency's purchasing power a rise in its price level would lead to a proportional decrease in that currency's valuation on the foreign exchange market.

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. Similarly, when exchange rates deviate significantly from their long term equilibrium due to speculative attacks or carry trade, a PPP exchange rate offers a better alternative for comparison.

What Is Purchasing Power Parity (PPP)?

In , the Big Mac Index was used to identify manipulation of inflation numbers by Argentina. Argentina responded by manipulating the Big Mac Index. The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level ; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods.

It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries.

Thus, it is necessary to make adjustments for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat more bread; Chinese more rice. Additional statistical difficulties arise with multilateral comparisons when as is usually the case more than two countries are to be compared.

Various ways of averaging bilateral PPPs can provide a more stable multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes.

Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program , which PPP estimates are based on, require the disaggregation of national accounts into production, expenditure or in some cases income, and not all participating countries routinely disaggregate their data into such categories.

Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is not commercially available in Thailand and rice is not in Ethiopia, so the price of rice in Ethiopia or teff in Thailand cannot be determined.

As a general rule, the more similar the price structure between countries, the more valid the PPP comparison. PPP levels will also vary based on the formula used to calculate price matrices.

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Linking regions presents another methodological difficulty. In the ICP round, regions were compared by using a list of some 1, identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region.

While this was superior to earlier "bridging" methods, which do not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries. There are a number of reasons that different measures do not perfectly reflect standards of living.

The goods that the currency has the "power" to purchase are a basket of goods of different types:. The more that 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. See also Penn effect.

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 Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services "haircuts" , and domestically produced crops.

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 Ethiopia , as against high income countries like Switzerland.

The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes farther in low-income countries than high, the relative pay differentials inter-country can be sustained for longer than would be the case otherwise. 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.

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. These act as a cheaper factor of production than is available to factories in richer countries.

Why Does a Big Mac Cost a Lot Less in China?

The Bhagwati—Kravis—Lipsey view provides a somewhat different explanation from the Balassa—Samuelson theory. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity.

PPP (Purchasing Power Parity) Exchange Rates

Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive. PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.

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The law of one price, the underlying mechanism behind PPP, is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price. As transport costs increase, the larger the range of exchange rate fluctuations.