Purchasing Power Parity (PPP)

Introduction

• Purchasing Power Parity (PPP) is defined as the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market as one dollar would buy in the US. 
• The basis for PPP is the “law of one price”.

Calculation of Purchasing Power Parity

• The technique of purchasing power parity allows us to estimate what exchange between two currencies is needed to express the accurate purchasing power of the two currencies in the respective countries.
• Suppose it costs $10 to buy a shirt in the US, and it costs INR 950 to buy an identical shirt in India. To make a comparison, we must first convert the INR 950 into US dollars. 

Therefore, using the formula:

S= INR 950 (P1)USD 10 (P2) = INR 95

 (P1 = Cost of Goods in Currency-1; and P2 = Cost of Goods in US Dollar)

• Therefore, Purchasing Power Parity of India w.r.t US.  is INR 95/ US Dollar. If the Exchange rate of INR w.r.t US Dollar is 70 (i.e, 1 USD= INR 70), then the same shirt which costs $10 in the US, costs only US $1.34 in India. 
• Thus, while computing GDP using PPP, INR 95 ($1.34) will be taken into account, rather than taking INR 950.  

Significance of Purchasing Power Parity

• Purchasing Power Parity is vital for converting measures of economic activities to be comparable across economies.
• It is calculated based on the price of a common basket of goods and services in each participating economy and is a measure of what an economy’s local currency can buy in another economy.
• Market exchange rate-based conversions reflect both price and volume differences in expenditures and are thus inappropriate for volume comparisons.

Important Points

• The value of the PPP exchange rate is very dependent on the basket of goods chosen. Organizations that compute PPP exchange rates use different baskets of goods and can come up with different values.
• The PPP exchange rate may not match the market exchange rate. The market rate is more volatile because it reacts to changes in demand at each location. 
• Because PPP exchange rates are more stable and are less affected by tariffs, they are used for many international comparisons, such as comparing countries’ GDPs or other national income statistics. These numbers often come with the label PPP-adjusted.

Issues with Purchasing Power Parity

• Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level.
• Transport Costs: Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than identical locally sourced goods.
• Tax Differences: Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.
• Government Intervention: Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.