See
also: List of Economic Topics 
PURCHASING
POWER PARITY - macroeconomics
In
economics, purchasing power parity (PPP) is a method used to calculate an alternative
exchange rate between the currencies of two countries. The PPP measures how much
a currency can buy in terms of an international measure (usually dollars), since
goods and services have different prices in some countries than in others.
PPP
exchange rates are used in international comparisons of standard of living. A
country's GDP is originally tallied in its local currency, so any comparison between
two countries requires converting currency. Comparisons using real exchange rates
are considered unrealistic, since they do not reflect price differences between
the countries. The differences between PPP and real exchange rates can be significant.
For example, GDP per capita in Mexico is ca. 6,100 U.S. Dollars, while on a PPP
basis, it is 9,000$ (U.S. GDP/capita is 37,388$, as of 2004).
Definition
PPP
is a theoretical exchange rate derived from the perceived parity of purchasing
power of a currency in relation to another currency. It takes into account that
some goods like real estate, services (e.g. medical services) and heavy items
are non-traded, and thus not reflected in the exchange rate. In contrast to the
"real" exchange rate that the currencies are traded for in the official
market (as opposed to the black market), the PPP exchange rate is calculated from
the relative value of a currency based on the amount of a "basket" of
goods the currency will buy in its nation of usage. Typically, the prices of many
goods will be considered, and weighted according to their importance in the economy.
The most common PPP exchange rate comes from comparing goods in a GDP reporting
area with equivalent goods in the United States and through that come up with
a PPP US dollar exchange rate. When GDP numbers from reporting regions are converted
through this PPP exchange rate it's considered to be a better comparison of standard
of living.
Method
The
PPP method considers a bundle of goods, then calculates the price of this bundle
in each country (using the country's local currency.) To calculate the exchange
rate between two currencies, one takes the ratio of the prices.
A
simple example of a measure of absolute 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. In the same way, if a
Big Mac or any basket of goods costs USD$4 in the US, the PPP exchange rate is
always $4 for $4.
Relative
PPP
Relative
PPP is concerned with change of price levels over different periods, also known
as inflation rate. The equation looks like
,
whereby
St is the spot_rate and Pt is the price in period t (Foreign values are marked
by an asterisk). 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 PPP of the USD has to depreciate
by 2% compared to the PPP of the EUR (or alternatively the EUR will appreciate
by 2%).
PPP
equalization and the law of one price
The
law of one price states that prices of traded goods will equalize in the absence
of tariffs, other barriers to trade and prohibitively high shipping rates. Free
trade of goods should revert exchange rates to their PPP values; for a discussion,
see Discussion and clarification of PPP.
Application
A
common measure of the standard of living is the per capita Gross Domestic Product,
which is calculated by dividing the GDP of a country by its population. In order
to compare the standard of living in two nations, one first needs to express these
numbers in the same currency. Using actual exchange rates when making these comparisons
can give a very misleading picture of living standards. The PPP method is used
to as an alternative.
For
example, if the value of the Mexican peso falls by half compared to the US dollar,
the 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 any poorer; 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 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.
Examples
West
and Central African Franc
During
2003 the US Dollar bought on average about 550 CFA franc. Because of a difference
in the perceived "purchasing power parity" within some of the regions
using the CFA franc, their purchasing power parity exchange rate differed like
this (lower is stronger parity): 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 uses the purchase power parity method in its calculations of Gross National
Product [1] (http://www.cia.gov/cia/publications/factbook/fields/2001.html). By
this measure the People's Republic of China has the second largest economy in
the world, $6.449 trillion (2004 est.) (CIA methodology for PPP (http://www.cia.gov/cia/publications/factbook/docs/notesanddefs.html)).
PPP:
clarification
Economics,
Banking & Finance
