The Purchasing Power Parity (PPP) principle asserts that currency fluctuations achieve balance when their buying power is equal in both nations. This means the currency value should correspond to the ratio of the two nations’ prices for a given basket of consumer goods.
The “law of one price” underpins PPP, stating that, in the absence of shipping and other transaction expenses, when prices are denominated in the same currencies, competing marketplaces will equalize the price of an item listed in two nations.
- Purchasing Power Parity (PPP) is defined as the number of units of a country’s currency needed to buy the same number of products in the domestic economy as one dollar would purchase in the United States.
- The purchase power parity approach allows us to determine the exchange rate required between two currencies to accurately reflect the buying power of the currency pairs in their respective nations.
- For example, a cell phone priced at approximately 3000 rupees in India would cost around USD 40 in the United States if the exchange rate is 75 rupees to one dollar.
- The formula for purchasing power parity is as follows:
- The formula S equals P1 divided by P2 represents the exchange rate of one currency to another, where:
- S denotes the rate of exchange.
- P1 is the price of a product in currency 1.
- P2 is the price of the same product in currency 2.
- This formula serves as a widely utilized macroeconomic indicator for comparing the currencies of different nations, employing a method known as the “basket of products.” It allows analysts to compare productive capacity and quality of life across nations.
Versions of PPP
- Analysts employ two distinct definitions of PPP: Absolute PPP and Relative PPP.
- Absolute PPP theory pertains to the equalization of prices between nations, whereas relative PPP concerns the fluctuation rates of prices, specifically inflation rates.
- This argument posits that the exchange rate is proportional to the disparity between the inflation rates of the overseas and native nations.
Significance of Purchasing Power Parity
- Buying Ability Governing parties are essential for standardizing economic growth indicators across countries. This is calculated using the prices of a shared basket of products in each member economy and acts as a proxy for the purchasing power of one economy’s domestic currency in another economy.
- Commodity currency exchange adjustments consider both price movements and expenditure variations, rendering them inappropriate for volume assessments. PPP-based spending translations diminish the impact of price level variations across countries and solely reflect volume disparities.
International Comparison Programme
The International Comparison Program (ICP) stands as one of the largest statistics efforts globally. It involves a density estimation endeavor, collecting relative pricing data and estimating the purchasing power parities of countries worldwide. Administered by the World Bank on behalf of the United States Commission, the ICP engaged 176 countries in its 2017 cycle, with the next assessment slated for 2021.
The primary aims of the International Comparison Program are:
- To generate purchasing power parities (PPPs) and Price Level Indices (PLIs) for member countries. PLIs, normalized averages of price relationships for specific products or demand, facilitate comparisons of costs across timeframes or geographical areas. They find applications in various sectors, aiding manufacturers in business planning and pricing strategies and guiding investments.
- To convert quantity and per capita measurements of Gross Domestic Product (GDP) and its spending components into a single currency using PPPs. GDP, a crucial indicator of profitability, quantifies a country’s productive capacity over time and the revenue generated by production or total spending on goods and services. It remains the foremost metric of economic activity.
Important Highlights
- India holds the position as the world’s third-largest economy by PPP-based share of global Average Personal Expenditure and Net Wealth Creation.
- Gross fixed capital formation (GFCF), crucial for a country’s official statistics, notably tracked by the UN System, shapes the economy. Notably, real estate trade and acquisition stand as a significant exception in GFCF.
- Gross fixed capital formation encompasses total dividends and is derived from the sum of a producer’s purchases, adjusted for fixed asset disposals and quasi assets.
- In 2017, India contributed 20.83 percent of the world’s largest total GDP in PPP terms, amounting to USD 8,051 billion within a total GDP of USD 119,547 billion, compared to China’s 16.4 percent and the US’s 16.3 percent.
- Among emerging economies, India retained its second-largest economic growth.
- In terms of PPP-based proportion of region Actual Personal Expenditure and Gross Asset Creation, India ranks as the world’s second-biggest economy, following China with 50.76 percent, and Indonesia with 7.49 percent.
Note Points
- The value of the PPP exchange rate heavily depends on the selected basket of products. Typically, commodities are chosen to closely adhere to the “rule of one price”, ensuring they are readily exchanged and widely available in both locations. Organizations calculating PPP exchange rates utilize various bundles of items, resulting in different values.
- The PPP exchange rate may deviate from the market rate, as the latter is more affected by demand fluctuations at specific locations, along with tariffs and wage differentials leading to longer-term disparities. PPP can forecast currency values over a relatively extended period due to its stability.
- Because PPP currency values are more predictable and less affected by barriers, they are frequently employed for comparing countries, such as in comparing Gross Domestic Product (GDP) or other government revenue figures. These figures are commonly referred to as PPP-adjusted.
Issues with Purchasing Power Parity
Calculating purchasing power parity faces challenges due to variations in market prices across nations. Several factors contribute to this complexity:
- Transport Costs: Imported goods incur transportation costs, including fuel expenses and import tariffs, making them more expensive than domestically produced items.
- Tax Differences: Differences in official tax rates, like the value-added tax (VAT), can lead to pricing disparities between countries.
- Government Intervention: Tariffs imposed by governments may raise the cost of foreign goods, even if they are cheaper elsewhere.
- Market Competition: In some countries, goods may be deliberately priced higher due to market competition strategies. Companies with dominance or part of cartels may inflate prices unfairly.
These factors complicate the determination of purchasing power parity by introducing significant variations in prices across different regions.
The Big Mac Index
- The Big Mac Index is a tool developed by The Economist magazine in London. It’s based on the concept of purchasing power parity (PPP), which aims to compare the relative value of two different currencies by examining their purchasing power. Specifically, it evaluates the exchange rate between two currencies by using the prices of a specific product, the Big Mac hamburger, sold by McDonald’s.
- For instance, this index allows one to assess the purchasing power parity between the Indian Rupee (INR) and the US Dollar (USD) based on the prices of a Big Mac in the United States compared to a similar product, such as the Maharaja Burger in India.
- The Big Mac Index often indicates that the exchange rate should be around 20 to 25 Indian Rupees per US dollar to achieve purchasing power parity. If the actual exchange rate differs significantly from this estimate, it suggests that the currency may be undervalued or overvalued.
- One advantage of using PPP and the Big Mac Index is that it provides a practical way to understand the relative value of currencies on a day-to-day basis. It offers a more stable and fundamental perspective of currency valuation compared to the sometimes volatile currency exchange rate markets.
FAQs
Q: What is Purchasing Power Parity (PPP)?
A: Purchasing Power Parity (PPP) is a theory in economics that suggests exchange rates between currencies should adjust to equalize the purchasing power of different currencies for a given basket of goods and services. In simpler terms, it means that in the absence of transportation costs and trade barriers, identical goods should have the same price in different countries when expressed in a common currency.
Q: How is Purchasing Power Parity (PPP) Calculated?
- PPP can be calculated using the formula: PPP = (Price of a Basket of Goods in Foreign Currency) / (Price of the Same Basket of Goods in Domestic Currency).
- This calculation helps determine the exchange rate that would make the purchasing power of two currencies equal.
Q: What are the Implications of Purchasing Power Parity (PPP)?
A: PPP has significant implications for international trade and investment. If a currency is overvalued according to PPP, it suggests that the currency is overpriced compared to its actual purchasing power, making exports more expensive and imports cheaper. Conversely, an undervalued currency according to PPP indicates that the currency is underpriced, which could stimulate exports and reduce imports.
Q: How Accurate is Purchasing Power Parity (PPP) in Practice?
A: While PPP is a useful concept in theory, in practice, it has limitations. Factors such as differences in taxes, regulations, transportation costs, and non-tradable goods can cause deviations from PPP. Additionally, PPP may not hold in the short term due to factors like speculative currency trading, inflation differentials, and market sentiment.
Q: What Role Does Purchasing Power Parity (PPP) Play in Economic Policy?
A: PPP is often used by policymakers and economists to assess the fair value of currencies and evaluate whether a currency is overvalued or undervalued. Governments may adjust their monetary or fiscal policies based on PPP assessments to maintain stable exchange rates or improve trade balances. However, PPP is just one of many indicators considered in economic policy-making.
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