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Home / IAS Preparation / Purchasing Power Parity

Purchasing Power Parity (PPP): Example, Calculation, Types & Significance

Last Updated on Nov 28, 2024
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Purchasing Power Parity (PPP) is an economic theory and a measure that measures the relative value of currencies by comparing the cost of a standard basket of goods and services in different countries. The basic idea of purchasing power parity is that, abstracting from transportation costs and other sources of friction, the same goods or services should sell for the same price in different countries when prices are translated into a common currency. Such a principle allows economists to obtain an estimate of the cost of living and economic efficiency in different countries by allowing for differences in price levels. Understanding PPP is quite essential for analyzing global economic conditions, exchange rates, and living standards.

The topic purchasing power parity is relevant to General Studies Paper III under the subject of Economic Development. To analyze international economic comparisons, currency value assessments, and measurement of economic welfare of different countries, aspirants need to understand PPP.

GS Paper

General Studies Paper III

Topics for UPSC Prelims

International Monetary Fund, World Bank, Nominal Exchange Rates, Big Mac Index

Topics for UPSC Mains

Comparison of PPP and Exchange Rate Methods, Impact on Global Economic Stability, Challenges and Limitations of Measuring PPP

What is Purchasing Power Parity?

Purchasing Power Parity, or PPP, is a technique to determine the relative value of different currencies by comparing the amount of goods and services that one unit of currency can purchase in different countries. This concept eliminates differences in price levels between countries and thus provides a more accurate measure of economic conditions and standards of living. PPP is founded on the theory of one price, which holds that if transportation costs and other impediments are absent, identical goods should have the same price when expressed in a common currency.

Purchasing Power Parity Example

To explain PPP with an example, let's use the price of a Big Mac burger, which is an often used illustration in the "Big Mac Index" presented by The Economist. Let's assume that a Big Mac costs $5 in the United States and 20 Chinese yuan in China. With an exchange rate of 1 USD = 6.5 CNY, the cost of the Big Mac in USD in China is 20 CNY / 6.5 = $3.08 approximately. According to PPP, if the purchasing power parity held true, the exchange rate would be such that the Big Mac would cost the same in both countries when expressed in the same currency. Therefore, the exchange rate should be 1 USD = 4 CNY (given 20 CNY / 5 USD).

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Purchasing Power Parity Theory

This theory is based on the law of one price, which states that under a free and efficient market, equivalent goods must have a uniform price expressed in a common currency without considering the cost of any transaction. Theory about purchasing power parity is employed for comparison of economic productivity as well as living standards across different countries.

How to Calculate Purchasing Power Parity?

To calculate PPP, there are several steps:

  • Identify a basket of goods and services: This basket is supposed to be a representation of typical consumption within the countries in comparison.
  • Calculate the prices of the basket in each country: Compile all the costs of the selected items in local currencies.
  • Converting the prices to the common currency: Using current exchange rate, convert the price from the local currency into a common reference currency, presumably the US dollar.
  • PPP exchange rate calculation: This is the rate obtained when the two currencies are compared with respect to the total cost of the basket of goods. For instance, if the basket costs $100 in the US and £80 in the UK, then the PPP exchange rate is 1 USD = 0.8 GBP.

The formula for PPP can be represented as: 

where,

E_{PPP} is the PPP exchange rate,

P1 is the price level in country A, and 

P2 is the price level in country B.

Read the article on the Difference Between Microeconomics and Macroeconomics!

Types of Purchasing Power Parity

The three types of PPP have been explained in brief:

Absolute PPP

Absolute PPP posits that exchange rates between two currencies must be set at the level of the price ratio for a predetermined basket of goods and services between the two countries. That is, this PPP version contends that, in theory, ideally a frictionless world with complete competition, an identical commodity must have an equal value in the two nations when using the same currency. 

Relative PPP

Relative PPP takes into account changes in price levels over time due to inflation. It implies that the rate of change in the exchange rate between two currencies during a period should be equal to the difference in inflation rates between the two countries. Therefore, if a country has higher inflation than another, its currency should depreciate relative to the other currency. 

Expenditure PPP

Expenditure PPP calculates PPP on the basis of some categories of expenditure like government consumption, private consumption, and capital formation. It offers more refined information on relative prices because it is calculated by comparison of the price of a bigger consumption basket as opposed to that of goods and services alone. This kind of measure enables better and more encompassing comparisons of countries' standards of living and their productivity levels.

Read the article on the Consumer Price Index (CPI)!

Purchasing Power Parity Index

The Purchasing Power Parity Index compares the economic productivity and standards of living between different nations by adjusting for differences in price levels. Organizations, like the World Bank and International Monetary Fund (IMF), make public PPP indices. Of course, the importance of the PPP index should never be underestimated in conducting further economic analysis and policymaking by comparing the benchmark of gross domestic product, poverty rates, income distribution, or people's living standards within two countries.

The World Bank estimated India's GDP per capita in PPP terms to be about $8,477 in 2023. This is in contrast to developed economies such as the United States, whose GDP per capita in PPP terms was estimated to be around $76,398.

Read the article on Inflation in India!

Significance of Purchasing Power Parity

PPP has deep economic implications:

  • Comparative Analysis: PPP enables better comparisons of economic productivity and living standards across nations by removing distortions caused by fluctuating exchange rates.
  • Economic Policy: Using PPP, policymakers make more rational decisions about monetary policy, fiscal spending, and social welfare programs.
  • Global Trade: Understanding competitiveness in the global market by accounting for price level differences is possible through PPP.
  • Investment Decisions: International investors utilize PPP to make relative valuation of investments among countries, after having considered risk due to changes in currency.
  • Measurement of Living Standards: Agencies such as World Bank and UN have been utilizing PPP to gauge the extent of poverty, inequality of income distribution, and living standards in different nations.

Read the article on Inflation Targeting!

Issues Associated with Purchasing Power Parity

Despite the above-said benefits of PPP, there are many limitations of using it:

  • Basket of Goods: The choice of goods and services to include in the comparison basket is not going to reflect perfectly the consumption pattern of various countries. Hence, it leads to error.
  • Non-Traded Goods: PPP does not account for non-traded goods and services, which creates significant differences in the cost of living among countries.
  • Quality Differences: PPP fails to capture differences in the quality of goods and services. This might lead to an over or underestimation of the purchasing power.
  • Market Imperfections: Transportation costs, tariffs, and differences in product availability can affect the validity of PPP calculations.
  • Exchange Rate Volatility: Short-term exchange rate movements do not always reflect basic price level differences, which can mislead the interpretation of PPP.

Read the article on Inflation Targeting!

More Articles for IAS Preparation

Purchasing Power Parity UPSC FAQs

This index compares the relative price levels of a fixed basket of goods and services between countries, adjusted to permit for the exchange rate, to measure economic productivity and living standards.

As of 2023, India's GDP per capita in PPP terms was estimated to be around $8,477 by the World Bank, which was the relative cost of living and economic productivity in comparison to other countries.

The purchasing power parity indicates the relative strength of currencies by comparing the cost of a standard basket of goods and services in different countries, which can provide insights regarding economic stability and living standards.

Purchasing Power Parity (PPP) is an economic theory suggesting that exchange rates between currencies should equalize the price of identical goods and services in any two countries.

The purchasing power parity formula is: [ E_{PPP} ={P1}/{P2} ] where E_{PPP} is the PPP exchange rate, P1 is the price level in country A, and P2 is the price level in country B.
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