Purchasing power parity

Purchasing power parity, or PPP, is a way to measure how much things cost in different countries. It helps us understand 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 very useful for comparing how well different countries are doing economically. 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 thousands of different items and services.

However, figuring out PPP can be tricky. Countries don't all buy the same things, so we need to carefully 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 how much things cost in different countries. They are useful when looking at things like how much a country makes and uses, especially for goods that aren’t traded between countries. Unlike regular market exchange rates, PPP rates stay more stable over time, which helps give a clearer picture of how well a country is doing.

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

Issues

The way we figure out purchasing power parity (PPP) can be tricky because it’s hard to find exactly 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, and entertainment prices might change even more. 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 what people buy and what shops sell can be very different in each country.

Because of these differences, we have to adjust for the quality of items. For example, people in the United States might eat more bread, while people in China might eat more rice. This means that PPP numbers can look different depending on which country we start from. When we compare many countries at once, it gets even harder. There are also many ways to average out these numbers, but each way has its own problems. Even with all 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, even though they are important to consider. When looking at PPP over time, we also need to think about how prices change due to inflation.

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. In general, the more similar the prices are between countries, the better the PPP comparison will be.

PPP numbers can also change depending on the method used to calculate them. There are several methods, each with its own strengths and weaknesses.

When comparing areas, there are extra challenges. In 2005, regions were compared using prices for about 1,000 items from 18 countries. This was better than older methods but might still give an unfair advantage to poorer 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 because it doesn’t always show the real differences in how people live. They think using market rates for GDP is more useful for some comparisons.

History

The idea of comparing the value of goods between countries started 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 develop the idea of purchasing power parity, or PPP, in papers for The Economic Journal. He suggested that fixing exchange rates based on PPP could help balance trade between countries. This idea came up 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

Each month, the Organisation for Economic Co-operation and Development measures price differences between its member countries by calculating the ratios of purchasing power parities for private final consumption expenditure to exchange rates. The table below shows how many US dollars are needed in each country to buy the same basket of goods and services that costs US$100 in the United States.

For example, an American visiting Switzerland would find it more expensive than the US, needing 27% more US dollars to buy the same goods and services.

To teach the idea and calculation of purchasing power parity, 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 and find out which currencies are overvalued or undervalued.

The Big Mac is good for this because it includes costs from many parts of the local economy, like ingredients, labor, advertising, rent, and transportation. 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 (like in India).

The Economist uses the Big Mac Index to see which currencies are overvalued or undervalued. For example, in January 2019, a Big Mac cost HK$20.00 in Hong Kong and US$5.58 in the United States. This suggests the Hong Kong dollar was undervalued by 54.2% compared to the US dollar.

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.

For example, in January 2016, the average price of KFC’s Original 12 pc. Bucket in the United States was $20.50, but in Namibia it was $13.40. This showed the Namibian dollar was undervalued by 33% at that time.

iPad Index

Like the Big Mac Index, the iPad index compares the price of an item in different places. Unlike the Big Mac, each iPad is made in the same place (except for Brazil) and all iPads of the same model work the same. Price differences come from things like transportation costs, taxes, and market prices. In 2013, an iPad cost about twice as much in Argentina as in the United States.