Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates In finance, the exchange rates between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1 based on relative price levels of two countries. The idea originated with the School of Salamanca The School of Salamanca is the renaissance of thought in diverse intellectual areas by Spanish theologians, rooted in the intellectual and pedagogical work of Francisco de Vitoria. From the beginning of the 16th century the traditional Catholic conception of man and of his relation to God and to the world had been assaulted by the rise of humanism, in the 16th century ^[1] and was developed in its modern form by Gustav Cassel Karl Gustav Cassel was a Swedish economist and professor of economics at Stockholm University in 1918.^[2] The concept is founded on the law of one price The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market the convergence on one price is instant; the idea that in absence of transaction costs, identical goods will have the same price in different markets.

In its "absolute" version, the purchasing power of different currencies In economics, the term currency can refer to a particular currency, for example Pound Sterling, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by means of is equalized for a given basket of goods The basket of consumer goods or consumer basket is the market basket intended for tracking the prices of consumer goods and services, i.e., it is a sample of goods and services, offered at the consumer market. The consumer basket is the base for the definition of the Consumer Price Index. In the "relative" version, the difference in the rate of change in prices at home and abroad - the difference in the inflation rates - is equal to the percentage depreciation or appreciation of the exchange rate.

The best-known and most-used purchasing power parity exchange rate is the Geary-Khamis dollar The Geary-Khamis dollar, also known as the international dollar, is a hypothetical unit of currency that has the same purchasing power that the U.S. dollar had in the United States at a given point in time. The years 1990 or 2000 are often used as a benchmark year for comparisons that run through time (the "international dollar").

PPP exchange rate (the "real exchange rate In finance, the exchange rates between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1") fluctuations are mostly due to different rates of inflation between the two economies. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are usually lower The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates. It has been a consistent econometric result for at least fifty years where incomes are lower. (A U.S. dollar The United States dollar is the official currency of the United States. The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents exchanged and spent in India India, officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with 1.18 billion people, and the most populous democracy in the world. Mainland India is bounded by the Indian Ocean on the south, the Arabian Sea on the west, and the Bay of Bengal on the will buy more haircuts than a dollar spent in the United States ^ b. English is the de facto language of American government and the sole language spoken at home by 80% of Americans age five and older. Spanish is the second most commonly spoken language). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces.

There can be marked differences between PPP and market exchange rates.^[3] For example, the World Bank's World Bank is a term used to describe an international financial institution that provides leveraged loans to developing countries for capital programs. The World Bank has a stated goal of reducing poverty World Development Indicators 2005 estimated that in 2003, one United States dollar The United States dollar is the official currency of the United States. The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents was equivalent to about 1.8 Chinese yuan The Renminbi is the official currency of the People's Republic of China (PRC), whose principal unit is the Yuan. The currency is legal tender in mainland China, but not in Hong Kong and Macau by purchasing power parity ^[4] — considerably different from the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita This article includes three lists of countries of the world sorted by their gross domestic product per capita at nominal values, the value of all final goods and services produced within a nation in a given year, converted at market exchange rates to current U.S. dollars, divided by the average population for the same year in the People's Republic of China b. ^ Simple characterizations of the political structure since the 1980s are no longer possible is about US$ The United States dollar is the official currency of the United States. The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Denmark's Denmark (pronounced /ˈdɛnmɑrk/ ; Danish: Danmark, pronounced [ˈd̥ænmɑɡ̊], archaic: [ˈd̥anmɑːɡ̊]) is a Scandinavian country in Northern Europe and the senior member of the Kingdom of Denmark. It is the southernmost of the Nordic countries, southwest of Sweden and south of Norway, and bordered to the south by Germany. Denmark borders nominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304.

PPP measurement

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 A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set. Typically, a price level is approximated with a price index; 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 A price index is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. 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. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit effects.

Big Mac Index

An example of one measure of PPP is the Big Mac Index The Big Mac Index is published by The Economist as an informal way of measuring the purchasing power parity between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. It "seeks to make exchange-rate theory a bit more digestible" popularized by The Economist The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London. Continuous publication began under founder James Wilson in September 1843. While The Economist calls itself a "newspaper", each issue appears on glossy, which looks at the prices of a Big Mac The Big Mac is a hamburger sold by the international fast-food chain McDonald's. It is one of the company's signature products. It consists of two 1.6 oz beef patties, special "Mac" sauce (a Thousand Island dressing variant), iceberg lettuce, American cheese, pickles, and onions, all served on a three part sesame seed bun burger in McDonald's McDonald's Corporation is the world's largest chain of hamburger fast food restaurants, serving nearly 47 million customers daily. At one time it was the largest global restaurant chain, but it has since been surpassed by multi-brand operator Yum! Brands (KFC, Taco Bell and others) and sandwich chain Subway restaurants in different countries. If a Big Mac costs US$ The United States dollar is the official currency of the United States. The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents4 in the United States ^ b. English is the de facto language of American government and the sole language spoken at home by 80% of Americans age five and older. Spanish is the second most commonly spoken language and GBP The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown dependencies (the Isle of Man and the Channel Islands) and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence (singular: penny)£3 in the United Kingdom, the PPP exchange rate In finance, the exchange rates between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1 would be £3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. The Big Mac Index is inaccurate in certain cases because of the different market conditions that exist in differing McDonald's locations. For instance, a Big Mac in downtown Chicago Chicago ( /ʃɨˈkɑːɡoʊ/ or /ʃɨˈkɔːɡoʊ/) is the largest city in both Illinois and the Midwest, and the third most populous city in the United States, with over 2.8 million people living within the city limits. Its metropolitan area, commonly named "Chicagoland", is the 26th most populous in the world, home to an estimated 9.7 is likely to be priced higher than one in Wisconsin The word Wisconsin has its origins in the name given to the Wisconsin River by one of the Algonquian speaking American Indian groups living in the region at the time of European contact. French explorer Jacques Marquette was the first European to reach the Wisconsin River and record its name, arriving in 1673 and calling the river Meskousing in. Such pricing differences existing in one country demonstrate the imperfection of the Big Mac Index. In addition, in some emerging economies western fast food represents an expensive niche product price well above the price of traditional staples - i.e. the Big Mac The Big Mac is a hamburger sold by the international fast-food chain McDonald's. It is one of the company's signature products. It consists of two 1.6 oz beef patties, special "Mac" sauce (a Thousand Island dressing variant), iceberg lettuce, American cheese, pickles, and onions, all served on a three part sesame seed bun is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners. Although it is not perfect, the index still offers significant insight and an easy example to the understanding of PPP.

Need for PPP adjustments to GDP

The exchange rate only reflects traded goods A tradable good or service can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the cost of transportation and the shorter the shelf life, the less tradable a good is. Prepared food, for example, is not generally in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets A well-known financial accounting textbook advises that the term be avoided except in tax accounting because it is used in so many different senses, not all of them well-defined. For example it is often used as a synonym for fixed assets or for investments in securities whose prices vary more than those of physical goods. Also, different interest rates An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to, speculation In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money or the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a, hedging In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, or interventions by central banks A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency. Like a normal commercial bank, a central bank charges interest on the loans made to borrowers, primarily the government of whichever country the bank exists for, and to other commercial banks, typically as can influence the foreign-exchange market The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

The PPP method is used as an alternative.

For example, if the value of the Mexican peso The peso is the currency of Mexico. The peso was the first currency in the world to use the "$" sign, which the United States dollar later adopted for its own use when the United States adopted the peso as currency during a period before adopting the dollar. The peso is the 12th most traded currency in the world and by far the most falls by half compared to the U.S. dollar The United States dollar is the official currency of the United States. The U.S. dollar is normally abbreviated as the dollar sign, $, or as USD or US$ to distinguish it from other dollar-denominated currencies and from others that use the $ symbol. It is divided into 100 cents, the Mexican Gross Domestic Product The gross domestic product or gross domestic income (GDI) is a measure of a country's overall economic output. It is the market value of all final goods and services made within the borders of a country in a year. It is often positively correlated with the standard of living, though its use as a stand-in for measuring the standard of living has 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 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.

Difficulties

The main reasons why different measures do not perfectly reflect standards of living are

• PPP numbers can vary with the specific basket of goods The term market basket or commodity bundle refers to a fixed list of items used specifically to track the progress of inflation in an economy or specific market used, making it a rough estimate.
• Differences in quality of goods are hard to measure and thereby reflect in PPP.

PPP calculations are often used to measure poverty rates The poverty threshold, or poverty line, is the minimum level of income deemed necessary to achieve an adequate standard of living in a given country. In practice, like the definition of poverty, the official or common understanding of the poverty line is significantly higher in developed countries than in developing countries.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
2. Tradable goods such as non-perishable commodities A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is fungible, i.e. the same no matter who produces it. Examples are petroleum, notebook paper, milk or copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereo systems, on the that can be sold on the international market (e.g. diamonds In mineralogy, diamond is an allotrope of carbon, where the carbon atoms are arranged in a variation of the face-centered cubic crystal structure called a diamond lattice. Diamond is less stable than graphite, but the conversion rate from diamond to graphite is negligible at ambient conditions. Diamond is renowned as a material with superlative).

The more 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. (For more details of why, see: 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 Chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. 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 China), 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 further 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.

PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.

Clarification to PPP Numbers of the IMF

The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that area's currency. The only time the PPP exchange rate and the market exchange rate can differ is when the GDP number is converted into another currency.

Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: [1]. The PPP exchange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.

See also

• Big Mac Index
• International dollar
• Relative Purchasing Power Parity
• List of cities by GDP
• List of countries by GDP (PPP)
• List of countries by GDP (PPP) per capita
• List of countries by future GDP (PPP) estimates
• List of countries by future GDP (PPP) per capita estimates
• Measures of national income and output
• Penn effect
• Karl Gustav Cassel
• Geary-Khamis dollar

Notes

1. ^ Alan M. Taylor y Mark P. Taylor (2004) "The Purchasing Power Parity Debate," NBER Working Paper No. 10607 (online).
2. ^ Gustav Cassel, "Abnormal Deviations in International Exchanges," in Economic Journal, (December, 1918), 413-415
3. ^ FT.com / World - China, India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04
4. ^ 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates

External links

• Penn World Table
• Explanations from the U. of British Columbia (also provides daily updated PPP charts)
• OECD Purchasing Power Parity estimates updated annually by the Organization for Economic Co-Operation and Development (OECD)
• World Bank International Comparison Project provides PPP estimates for a large number of countries
• UBS's "Prices and Earnings" Report 2006 Good report on purchasing power containing a Big Mac index as well as for staples such as bread and rice for 71 world cities.

Categories: Economic indicators | Index numbers | International economics | Gross Domestic Product

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