Home > Purchasing power parity
In economics, purchasing power parity (PPP) is a theoretical exchange rate derived from the perceived "parity" of "purchasing power" of a currency in relation to another currency. In contrast to the "real" exchange rate that the currencies are traded for in the official market (as opposed to the " black market"). The PPP exchage rate is calculated from the relative value of a currency based on the amount of "a basket" of goods the currency will buy in their nation of usage. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy. The most common PPP exchange rate comes from comparing goods in a GDP reporting area with the same or "equivalent" goods in the United States and through that come up with a PPP US dollar exchange rate. When GDP numbers from reporting regions are converted through this PPP exchange rate it's perceived to be a better comparison of " standard of living". For a current list see the IMF reporting areas reported Gross Domestic Product number and the PPP US dollar exchange rate used to convert it (2003): [1].1 Method
The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.
A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US and GBP£3 in Britain, the PPP exchange rate would be £3 for $4.
Relative PPP is concerned with change of price levels over different periods, also known as inflation rate. The equation looks like , whereby is the spot_rate and is the price in period t (Foreign values are marked by an asterisk). The change in the exchange rate is determined by price level changes in both countries. For example, if prices in the USA rise by 3% and prices in the European union rise by 1% the USD has to depreciate by 2% compared to the EUR (or alternatively the EUR will appreciate by 2%).
2 Application
A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to express these numbers in the same currency. Using actual exchange rates when making these comparisons can give a very misleading picture of living standards. The PPP method is used to as an alternative.
For example, if the value of the Mexican pesoThe peso is the currency of Mexico. It is divided into 100 centavos''. The symbol used for the peso is "$", while centavos are represented by "¢". Its current ISO 4217 code is MXN (prior to 1993 the code "MXP" was used). History The peso was originally ba falls by half compared to the US dollar, the Gross Domestic Product 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 any poorer; 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.
