Purchasing power parity

Purchasing power parity, or PPP, is a way to see how much things cost in different countries. It helps us know how strong a country's money really is by looking at the price of the same items, like food, clothes, and services, in each place. PPP is found by comparing the cost of a special group of goods and services, called a market basket, in one country to the cost of the same basket in another country.

PPP is useful for comparing how well different countries are doing. It can show us things like the total value of goods and services a country makes (its GDP), how productive people are at work, and what things cost for everyday people to buy. Some groups, like the OECD, use PPP to study these ideas by looking at the prices of many different items and services.

Figuring out PPP can be tricky because countries don't all buy the same things. We need to compare the prices of what people actually use in each place. This helps give a clearer picture of how different places are doing and what life is like for people living there.

Concept

Purchasing power parity (PPP) is an economic way to compare prices in different places. It helps us understand how much things really cost in various countries. Imagine a computer that costs 500 US dollars in New York and the same computer costs 2000 HK dollars in Hong Kong. PPP says the exchange rate should be 4 HK dollars for every 1 US dollar.

PPP is like a list of many items, such as a computer, rice, and steel, that we use to compare prices between places. If these items cost 1000 US dollars in New York and 6000 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar. This helps us see how much money people can buy in different countries.

PPP exchange rates can be different from the rates we see when we change money at a bank. This is because of things like taxes on goods and different costs for workers. PPP is useful for comparing how rich countries are by looking at things like how much each person makes in a year.

Usage

Purchasing power parity (PPP) exchange rates help us compare prices in different countries. They are useful for understanding a country's economy, especially for goods that aren’t traded between countries. Unlike regular exchange rates, PPP rates change less over time. This helps show how well a country is doing more clearly.

PPP exchange rates give a better picture of a country’s production because they consider the cost of living and prices in each country. For example, if a country’s currency loses value, it might seem like the country is doing worse. But with PPP, we can see that if prices and incomes stay the same, people there may not actually be worse off. PPP is especially helpful when a country’s exchange rate is controlled by the government or changed a lot by traders, as it gives a more realistic view of the country’s economy.

Issues

Figuring out purchasing power parity (PPP) can be tricky because it’s hard to find the same items to compare prices between countries.

Countries have different prices for different things. For example, food prices might change more than housing prices. People in different countries also buy different things. To compare, we need to look at the cost of similar groups of items and services, but this is difficult.

Because of these differences, PPP numbers can look different depending on which country we start from. When we compare many countries at once, it gets even harder. Even with these challenges, PPP is still a helpful way to compare countries, even if it’s not perfect.

For example, in 2005, gasoline cost about US$0.91 per gallon in Saudi Arabia but US$6.27 in Norway. These big price differences don’t always make PPP easier to figure out.

Besides the challenges of picking the right items to compare, PPP can also be affected by how well countries share their economic data. The International Comparison Program needs detailed information from countries, and not all countries can provide this data in the same way.

Some comparisons are impossible. For example, comparing someone in Ethiopia who eats teff with someone in Thailand who eats rice doesn’t work because teff isn’t sold in Thailand and rice isn’t sold in Ethiopia.

PPP numbers can also change depending on the method used to calculate them.

When comparing areas, there are extra challenges. In 2005, regions were compared using prices for about 1,000 items from 18 countries.

PPP isn’t a perfect way to measure how well people are doing. In 2011, the IMF said that using GDP with PPP might not be the best way to compare countries.

History

The idea of comparing the value of goods between countries began in the 1500s with the School of Salamanca. In 1802, Henry Thornton explained how exchange rates stay close to their true value in his book Paper Credit. Later, John Wheatley and David Ricardo supported these ideas.

In 1916, Gustav Cassel helped create the idea of purchasing power parity, or PPP, in papers for The Economic Journal. He thought that fixing exchange rates based on PPP could help balance trade between countries. This idea appeared when people were trying to restore the gold standard and fixed exchange rates after World War I, which they believed was important for stable international trade.

Calculating PPP factors

See also: List of countries by price level

Every month, the Organisation for Economic Co-operation and Development looks at price differences between its member countries. It does this by comparing the cost of a basket of goods and services to exchange rates. The table below shows how many US dollars are needed in each country to buy the same things that cost US$100 in the United States.

For example, an American visiting Switzerland would find it more expensive than the US.

To make the idea of purchasing power parity easier to understand, the basket of goods is often simplified to just one item.

Big Mac Index

Main article: Big Mac Index

The Big Mac Index is a simple way to show purchasing power parity using just one item: a Big Mac burger from McDonald's restaurants. It was created by The Economist in 1986 to help teach economics.

The Big Mac is good for this because it includes costs from many parts of the local economy. However, there are some problems. Big Macs don’t travel well, so prices can differ between places. Also, not every country has a McDonald’s, and not all McDonald’s sell Big Macs.

KFC Index

Main article: KFC Index

Similar to the Big Mac Index, the KFC Index uses a single item — a KFC Original 12/15 pc. bucket — to measure purchasing power parity. It was created because many African countries don’t have McDonald’s.