Encyclopedia  |   World Factbook  |   World Flags  |   Reference Tables  |   List of Lists     
   Academic Disciplines  |   Historical Timeline  |   Themed Timelines  |   Biographies  |   How-Tos     
Sponsor by The Tattoo Collection
Purchasing power parity
Main Page | See live article | Alphabetical index

Purchasing power parity

In economics, purchasing power parity (PPP) is a method used to calculate exchange rates between the currencies of different countries. PPP exchange rates are used in international comparisons of standard of living. They calculate the relative value of currencies based on what those currencies will buy in their nation of origin. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy.

Table of contents
1 Method
2 Application
3 Difficulties with PPP comparisons
4 See also
5 External links

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 and humorous 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%).

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 peso 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.

Difficulties with PPP comparisons

While using PPP exchange rates for comparison is an improvement over using actual exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another. The PPP method does not account for this.

A PPP exchange rate varies depending on the choice of goods used for the index. Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another.

Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the quality of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Thus, even a PPP-adjusted measure of GDP per capita must be used with caution, as it is only one component of quality of life.

For example, in 2002, the GDP per capita for Japan was about US$40,000 and the PPP was estimated as $27,000, while in the US, GDP per capita was about $27,500 and the PPP was $36,000. The US has higher crime rates and a greater extent of poverty and slums than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences.

Per capita income also does not take into account inequalities in wealth distribution.

See also

External links