What Is Purchasing Power Parity – PPP?
One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach.
According to this concept, two currencies are in equilibrium—known as the currencies being at par—when a basket of goods is priced the same in both countries, taking into account the exchange rates.
- Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts.
- PPP compares economic productivity and standards of living between countries.
- Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
Purchasing Power Parity (PPP)
Calculating Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
S represents the 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
Comparing Nations' Purchasing Power Parity
To make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. However, this one-to-one comparison is difficult to achieve due to the sheer amount of data that must be collected, and the complexity of the comparisons that must be drawn. So, to facilitate this with greater ease, in 1968, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP).
With this program, the PPPs generated by the ICP have a basis from a worldwide price survey that compares the prices of hundreds of various goods and services. The program helps international macroeconomists estimate global productivity and growth.
Every three years, the World Bank releases a report that compares various countries, in terms of PPP and U.S. dollars. Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use weights based on PPP metrics to make predictions and recommend economic policy. The recommended economic policies can have an immediate short-term impact on financial markets.
Also, some forex traders use PPP to find potentially overvalued or undervalued currencies. Investors who hold stock or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment.
Pairing Purchasing Power Parity With Gross Domestic Product
In contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of the goods and services produced within one country. Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation.
However, some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies.
To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5.
In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro.
Nations With the Highest PPP
There are five nations that have the highest GDP in market exchange terms. The list is as follows:
- United States
However, this comparison changes with the introduction of purchasing power parity. According to 2017 data from the International Monetary Fund, based on purchasing power, China boasts the world's largest economy, with 23,122 billion current international dollars. The U.S. comes in second with 19,362 billion. India, Japan, and Germany follow with 9,447 billion, 5,405 billion, and 4,150 billion, respectively.
Drawbacks of Purchasing Power Parity
Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac hamburger, across many countries. Their study results in the famed "Big Mac Index". In Burgernomics—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory does not line up with reality.
Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.
Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.
Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.
The Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.
Goods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.
The Bottom Line
While it's not a perfect measurement metric, purchase power parity does let one compare pricing between countries with differing currencies. Just don't try to buy a hamburger in Luxembourg if you plan on exchanging your money for Russian rubles!