Purchasing Power Parity (PPP)

The Purchasing Power Parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries.

PPP is the rate of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries.

That said, at a detail level, the purchasing power parity is the exchange rate that equates the price of a basket of identical traded goods and services in two countries.

This is so because the PPP theory assumes that the actions of importers and exporters, motivated by cross country price differences, induce changes in the spot exchange rate.

How purchasing power parity is calculated

The purchasing power parity (PPP) theory is based on an extension and variation of the law of one price as applied to the aggregate economy. It is calculated as:

       cost of goods in currency 1
PPP = --------------------------------
       cost of goods in currency 2

where PPP represents the exchange rate of currency 1 to currency 2.

In other words, the exchange rate adjusts in a way so that an identical good or a service in two different countries has the same price when expressed in the same currency.

For example, on a single good level, a McDonald's Big Mac that sells for C$3.63 in Canada should cost US$3.22 in a U.S. city when the exchange rate between Canada and the U.S. is 1.13 USD/CND.

This calculation is simplified to the Big Mac index level to illustrate the concept. The purchasing power parity applies the same concept just on a higher level, that is on a representative basket of goods and services.

If we look at this from another angle, the 1.13 USD/CND is the purchasing power parity in this case. Since exchange rates are volatile and influenced by many factors, the real market exchange rate can be higher or lower than the 1.13 USD/CND.

What happens if exchange rate deviates from PPP

Some economists argue that once the exchange rate moves away from its purchasing power parity, trade and financial flows in and out of a country can move away from their equilibrium.

This can result in potentially substantial trade and current account deficits or surpluses which however eventually tend to move the flows and the exchange rate back to their equilibrium.

What are the major uses of PPP?

The major use of PPP is as a first step in making inter-country comparisons in real terms of gross domestic product (GDP) and its component expenditures.

Calculating the PPP is the first step in the process of converting the level of GDP and its major aggregates, expressed in national currencies, into a common currency to enable these comparisons to be made.

The purchasing power parity in real world

The purchasing power parity (PPP) is often very different from the current market exchange rate.

Many goods and services that are in the reference basket are not traded across borders as the PPP theory demands.

Baskets of goods and services are not comparable accross borders. Goods that are included in the basket in one country many not be in the reference basket in another country.

Because it is not just traded goods that are affected, some economists argue that PPP is too narrow a measure for judging a currency's true value.