Purchasing Power Parity - PPP

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What is 'Purchasing Power Parity - PPP'

Purchasing power parity (PPP) is a theory in economics that approximates the total adjustment that must be made on the currency exchange rate between countries that allows the exchange to be equal to the purchasing power of each country’s currency.

The relative version of PPP is calculated as:

Purchasing Power Parity (PPP)

Where:
"S" represents exchange rate of currency 1 to currency 2
"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2

BREAKING DOWN 'Purchasing Power Parity - PPP'

To make a comparison of prices across countries that holds any type of meaning, a wide range of goods and services must be considered. The amount of data that must be collected, and the complexity of drawing comparisons, makes this process difficult. To facilitate this, the International Comparisons Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations. Purchasing power parities generated by the ICP are based on a worldwide price survey.

Using PPPs is the alternative to using market exchange rates. The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. PPP is determined in each country based on its relative cost of living and inflation rates. Purchasing power plus parity ultimately means equalizing the purchasing power of two differing currencies by accounting for differences in inflation rates and cost of living.

Every three years, the World Bank constructs and releases a report that compares various countries in terms of PPPs and U.S. dollars. These reports, evidenced through charts and graphs, reveal that typically when PPPs are used, the gap that exists between wealthy countries and poverty-stricken nations is narrowed substantially.

An Example of PPP

There is one commonly used example to make PPP more clear. This example uses the price of a hamburger. If a hamburger sells in London for £2 but sells for $4 in New York, the implication is the PPP exchange rate is £1 is equivalent to $2. However, this exchange rate may actually be different from the exchange rate prevailing in financial markets, meaning the actual dollar cost of the hamburger in London may be more or less than the $4 it sells for in New York. This form of cross-country comparison is the basis for the highly publicized “Big Mac” Index that was published by the Economist magazine. This index calculates PPP exchange rates based on McDonald’s Big Mac, a sandwich that is sold in nearly identical forms in a number of countries around the world.

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