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PPP, or purchasing power parity, is a metric used to study the living standards and productivity of two nations. It is an economic theory that differentiates currencies of two countries using a basket of goods approach. When prices of goods and services are the same or similar in two countries, the currencies of these two countries are said to be at par or equilibrium.
What is Purchasing Power Parity?
The estimation of costs in separate countries, that use particular goods’ prices to contrast the outright purchasing power of the country’s currency, is known as purchasing power parity or PPP.
For instance, if you buy a pair of shoes for ₹5,000 in India, it should cost $65.88 in the US.
PPP can be used to contrast economic productivity and standards of living. The inflation and exchange rate can vary from the market exchange rate due to tariffs, poverty, and various other transaction costs. PPP exchange rates can convert the national poverty line from a few of the poorest countries to find the global poverty line.
Purchasing Power Parity Formula
The idea behind the concept of purchasing power parity is that the exchange rate between countries should be at par so that consumers can purchase the same amount of goods and services across the globe. PPP is based on the law of one price, which defines that identical goods should have the same price. The purchasing power parity formula can be written as:
S = P1 / P2
Where,
S defines the exchange rate of one currency to another.
P1 is the price of goods in terms of currency 1.
P2 is the value of the price of the same goods in terms of currency 2.
Purchasing Power Parity And Exchange Rates
The supply and demand forces of traded goods and services help calculate a country’s exchange rate. However, it doesn’t consider the number of goods that are not traded, leading to inaccurate assumptions of living standards.
For example, a citizen of the United States visits India and buys 15 pastries for ₹150 and says that they are cheaper in India. The same pastries in the US cost $4 each. Therefore, 15 pastries cost ₹240 (if $1 = ₹60). At the same price, she can buy 24 pastries in India. So PPP for exchange rate is $1 = ₹10.
The exchange rate will not consider that pastries are cheaper in India because they are not traded goods. So, the exchange rate often disregards the living rate of developing countries.
This happens because developing nations reduce the factor of production, which means that the labour costs are generally lower. As a result, non-traded goods are cheaper.
When a country develops, the gap between the exchange rate and PPP reduces. This happens because the number of traded goods increases. PPP ratios can be considered a better method of contrasting living standards in different countries.
Purchasing Power Parity And Gross Domestic Product
Gross domestic product (GDP) is a term used in modern macroeconomics to describe the total monetary cost of the product generated within a single country. The monetary value in the present absolute terms is calculated using nominal GDP. The real gross domestic product inflation can be maintained using the nominal gross domestic product.
A few calculations go further to regulate GDP for the PPP value. This adaptation transforms nominal GDP into a number that can be easily compared across nations and diverse currencies.
For example, if you buy a skirt that costs $10 in the US, the same skirt costs £8 in Germany.
You need to make a product-to-product comparison to calculate this, which means you have to convert £8 into dollars. Assuming the exchange rate to be $15, PPP would be 15/10. So, it can be said that if you spend $1 on a skirt in America, you will pay $1.50 in Germany for the same skirt.
Uses of PPP
Due to significant differences in inflation rates worldwide, it is impossible to compare and determine the relative outcome of sectors of the economy and their standard of living. Variables based on PPP are expressed in real terms, allowing for analogies. According to the most recent estimates, the following diagram depicts the difference between nominal GDP and PPP-based GDP.
Purchasing power parity is an important part of the economy because it doesn’t have any significant fluctuations in the long run. PPP is also a way to measure whether the exchange rate will increase or decrease as the economy grows.
Conclusion
Purchasing power parity helps contrast the purchasing power of different world currencies. It is also called the theoretical exchange rate that unifies the price of products and services with another currency. It allows people to shop around the world so that they can get the same price as in their country.
