What is Purchasing Power Parity?

What is Purchasing Power Parity?

PPP or Purchasing Power Parity is an economical technique to determine or evaluate and if necessary make certain changes to ensure that the exchange rate of two currencies is at par with each other’s purchasing powers. This theory turns out to be quite accurate and useful in today’s global economy and market where the value of goods and services seem to be drastically apart due to varying factors that affect the same. For example, the demand of the good, the production and transportation, the availability of the good and a number of other. PPP helps calculate the pricing of these goods and services with the help of an equation. The equation is stated as S = P1 ÷ P2 where S is equal to the exchange rate of Currency 1 to Currency 2, P1 is equal to the price of a specific item in Currency 1, and P2 equals the price of the same item in Currency 2. The whole purpose of it is to lessen the misleading effects of changes in national currency but more importantly, maintain equilibrium. Similar to the Law of one price (LOP) which is to make sure that a good sold in Country X is at par when sold in Country Y after accounting for differences in interest rates and exchange rates. The process is not simple. A huge lot of goods are to be considered, the complexity of massive numbers and drawing comparisons is often difficult and endless. The International Comparisons Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations to help with this issue. The PPPs they generate are often from the worldwide price survey, considering almost everything. Global productivity and growth can hence be looked into by macro economists with ease. The World Bank to help releases a report every three years with a list of countries in terms of the PPPs and US dollars. The IMF and the OECD also use weights based on PPP to help with economic policies. It’s also an alternative to using market exchange rates. The Big Mac Index is a great example. An economist to test the PPP annually tracked the price of the Big Mac burger from McDonald’s Corp’s in every country every year since 1986. China, according to a report by IMG in 2017, is the leading economy in terms of purchasing power parity, with 23,122 billion current international dollars. The United States of America follows close enough. India, Japan and Germany then fall in line.

Even though not perfect, it definitely is an important economic tool helping macro economists, countries and the global market work and grow. Now you know, think twice about the PPP before you buy anything outside your country!

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