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Macroeconomic analysis is based on various metrics that are used to compare standards of living and economic productivity between countries across time. One such widely used metric is purchasing power parity (PPP).

Purchasing power parity (PPP)  compares countries’ currencies via “basket of goods” approach. This theory states that two currencies are said to be in equilibrium or at par when the basket of goods (considering the exchange rate) is priced equally in both countries. Similar to the PPP, the law of one price (LOP) is an economic theory, projecting, after accounting interest rates and exchange rates differences, that the cost of a good in country X must be the same as that in country Y in real terms.

How to Calculate Purchasing Power Parity

The PPP (relative version) is computed by the following formula:

Purchasing Power Parity (PPP) : S = P1 / P2

Where:

S is the exchange rate of currency 1 to currency 2

P1 is the cost of good X in currency 1

P2 is the cost of good X in currency 2

How PPP Is Used

A broad range of goods and services is taken into an account to make the comparison of prices across countries. The process is difficult since it involves huge data collection and complex analysis.  The International Comparisons Program (ICP) was formed 1968 by the University of Pennsylvania and the United Nations, to facilitate this process. Purchasing power parities resulted by the ICP are reliant on global price survey comparing the prices of hundreds of different goods. This data, thus, helps global macroeconomists make the estimates of global growth and productivity.

The World Bank develops and publishes a report in every three years, which compares various countries in terms of the PPP and U.S. dollars. Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) apply weights based on PPP metrics to develop predictions and suggest economic policy. These actions usually influence the financial markets, especially in the short run.

PPP is also used by forex traders to determine potentially undervalued or overvalued currencies. Investors having stock or bonds of foreign businesses often survey PPP numbers to project the effect of exchange-rate changes on a country’s economy.

PPP: The Alternative to Market Exchange Rates

PPP is the alternative to market exchange rates. The real purchasing power of the currency is the amount of that currency required to purchase a definite unit of a good or a basket of goods and services. Purchasing power is measured in each country on the basis of its relative cost of living as well as inflation rates. Purchasing power as well as parity equalizes the buying power of two varying currencies by considering the differences in cost of living and inflation rates.

The Big Mac Index: An Example of PPP

The Economist conducted the PPP annual test by tracking the McDonald’s Corp.’s Big Mac burger in various countries, from 1986. The Big Mac index determines the PPP between countries using Big Mac price as a benchmark. The Big Mac index recommends that theoretically the fluctuations in the exchange rates between currencies impact the price paid by a consumer in a country, replacing basket with a popular hamburger.

For instance, if the Big Mac price is \$4.00 in the U.S. and 2.5 pounds sterling in Britain, we expect the exchange rate as 1.60 (4/2.5 = 1.60). If dollars to pounds exchange rate is any greater, the Big Mac index will show that pound was overvalued, any lower and it will be undervalued.

It means the index is not free from flaws. First, the price of Big Mac is determined by McDonald’s Corp., which can greatly impact Big Mac index. Moreover, the Big Mac varies across the countries in terms of its size, ingredients as well as availability. Hence, this index is called light-hearted and makes an ideal example to be used academically to teach about PPP.

GDP and PPP

In modern macroeconomics, gross domestic product (GDP) implies the total monetary value of the final goods and services manufactured/developed within a country. Nominal GDP computes the monetary value in absolute, current terms. Real GDP takes into an account the nominal GDP and makes adjustment for inflation. Further, few accounts of GDP are also adjusted for PPP. This adjustment is made to change nominal GDP into a number, which makes it easier to compare countries having different currencies.

One way to recognize how GDP with PPP represents is to think about the net collective purchasing power of Japan if it is used to make the same purchases in the U.S. markets. It will only work when all yens are exchanged for US dollars. Otherwise, no comparison can be made.

The example given below explains this point.

Let’s say it costs \$10 to purchase a shirt in the U.S., while the same shirt costs €8.00 in Germany. To make an accurate comparison, the €8.00 in Germany must be first converted into U.S. dollars. If the exchange rate is like that the shirt in Germany costs \$15.00, the PPP will be 15/10, or 1.5. For each \$1.00 spent on a shirt in the U.S., it will take \$1.50 to get the same shirt in Germany.

Which Nations Have the Highest Purchasing Power?

The five nations having the highest GDP in terms of market exchange  are the U.S., China, India, Japan and Germany. Upon applying PPP, this comparison changes. As per 2017 data published by the International Monetary Fund (IMF), China has superseded U.S. as the world’s biggest economy based on the buying power with 23,122 billion present  international dollars. The U.S. ranks the second with 19,362 billion. Japan, India and Germany are on 3rd, 4th and 5th rank with 9,447 billion, 5,405 billion, and 4,150 billion, respectively.

The Downfalls of PPP: Short-Term vs. Long-Term Parity

Based on empirical evidence, we have observed that a lot of goods and baskets of goods dont have PPP  in the short-term, and uncertainty prevails if PPP is applied in the long run. A popular paper “Burgernomics,” (2003) comprehends the Big Mac Index and PPP, wherein the authors Michael Pakko and Patricia Pollard quote various factors as to why PPP theory is not closely related with reality:

Transport costs: Goods not available locally are to be imported, which leads to transport costs. Imported goods are therefore sold at a comparatively higher price than the same goods obtained from the local sources.

Taxes: When government sales taxes, like value-added tax (VAT), are high in a country as compared to another, it implies that goods will sell at a higher price in the high-tax country.

Government intervention: Import tariffs increase the imported goods. Where tariffs restrict supply, the demand increases, causing the goods’ price to rise as well. In countries having the same good as unrestricted and abundant, the price will be less.

Non-traded services: The Big Mac’s price consists of input costs, which are not traded. Hence,  those costs are to be parity internationally. These costs may include storefront, utility expense, insurance, and the labor cost.

As per PPP, the countries having non-traded service, have relatively higher costs and relatively more expensive goods, causing the currencies to be overvalued as compared to the currencies in countries having low costs of the non-traded services.

Market competition: Goods are intentionally priced higher in a country as the company enjoys a competitive advantage, either because of its monopoly or it is part of a group of price setting companies.

Inflation: The rate based on which the price of goods (or baskets of goods) changes in the countries. It shows the value of those countries’ currencies.

Conclusion

While not ideal, PPP does let us compare the pricing between countries having differing currencies.

Research articles for Purchasing Power Parity (PPP)

Modeling deviations from purchasing power parity (PPP), Aizenman, J. (1984). International Economic Review, 175-191.

An empirical investigation of purchasing power parity (PPP) for Turkey, Alba, J. D., & Park, D. (2005). Journal of Policy Modeling, 27(8), 989-1000.

Purchasingpowerparity (PPP) approach to energy-efficiency measurement: implications for energy and environmental policy, Birol, F., & Okogu, B. E. (1997). Energy, 22(1), 7-16.

[PDF] International migration, purchasing power parity (PPP) and the money metric of welfare gains, Timmer, H., & van der Mensbrugghe, D. (2001). In 9th Annual Conference on Global Economic Analysis, Addis Ababa, Ethiopia (15–17 June).

[PDF] Explaining the long-term real equilibrium exchange rates through purchasing power parity (PPP): An empirical investigation on Egypt, Jordan and Turkey, Abumustafa, N. I., & Feridun, M. (2010). African Journal of Business Management, 4(7).

Covered Purchasing Power Parity, ex-ante PPP and Risk Aversion, Moore, M. J. (1992). CEPR Discussion Papers.

An Empirical Investigation Of Purchasing Power Parity (PPP) For NORDIC Countries: Evidence From Linear And Nonlinear Unit Root Tests., GÜRİŞ, B., YAŞGÜL, Y. S., & TIRAŞOĞLU, M. (2016). International Journal of Economic Perspectives, 10(1).

A test of Purchasing Power Parity (PPP) theory and the International Fisher Effect: A case of the US dollar and the Japanese yen, Kulkarni, K. G. (1990). The journal of applied business research. Vol, 7.