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Purchasing power parity (PPP)[1] is a measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currencies. In many cases, PPP produces an inflation rate that is equal to the price of the basket of goods at one location divided by the price of the basket of goods at a different location. The PPP inflation and exchange rate may differ from the market exchange rate because of poverty, tariffs, and other transaction costs.

Concept

Purchasing power parity is an economic term for measuring prices at different locations. It is based on the law of one price, which says that, if there are no transaction costs nor trade barriers for a particular good, then the price for that good should be the same at every location.[1] Ideally, a computer in New York and in Hong Kong should have the same price. If its price is 500 US dollars in New York and the same computer costs 2000 HK dollars in Hong Kong, PPP theory says the exchange rate should be 4 HK dollars for every 1 US dollar.

Poverty, tariffs, and other frictions prevent trading and purchasing of various goods, so measuring a single good can cause a large error. The PPP term accounts for this by using a basket of goods, that is, many goods with different quantities. PPP then computes an inflation and exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location. For example, if a basket consisting of 1 computer, 1 ton of rice, and 1 ton of steel was 1800 US dollars in New York and the same goods cost 10800 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar.

The name purchasing power parity comes from the idea that, with the right exchange rate, consumers in every location will have the same economic term for measuring prices at different locations. It is based on the law of one price, which says that, if there are no transaction costs nor trade barriers for a particular good, then the price for that good should be the same at every location.[1] Ideally, a computer in New York and in Hong Kong should have the same price. If its price is 500 US dollars in New York and the same computer costs 2000 HK dollars in Hong Kong, PPP theory says the exchange rate should be 4 HK dollars for every 1 US dollar.

Poverty, tariffs, and other frictions prevent trading and purchasing of various goods, so measuring a single good can cause a large error. The PPP term accounts for this by using a basket of goods, that is, many goods with different quantities. PPP then computes an inflation and exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location. For example, if a basket consisting of 1 computer, 1 ton of rice, and 1 ton of steel was 1800 US dollars in New York and the same goods cost 10800 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar.

The name purchasing power parity comes from the idea that, with the right exchange rate, consumers in every location will have the same purchasing power.

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the law of one price. So, ones traded easily and are commonly available in both locations. 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. Also, tariffs and difference in the price of labor (see Balassa–Samuelson theorem) can contribute to longer term differences between the two rates. One use of PPP is to predict longer term exchange rates.

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.

There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[2] A well-known purchasing power adjustment is the Geary–Khamis dollar (the international dollar). The World Bank's World Development Indicators 2005 estimated that in 2003, one Geary–Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[3]—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,965[4] while on a PPP basis it is about US$7,197.[5] At the other extreme, for instance Denmark's nominal GDP per capita is around US$53,242, but its PPP figure is US$46,602, in line with other developed nations.

Variations

There are variations to calculating PPP. The EKS method (developed by Ö. Éltető, P. Köves and B. Szulc) uses the geometric mean of the exchange rates computed for individual goods.[6] The EKS-S method (by Éltető, Köves, Szulc, and Sergeev) uses two different baskets, one for each country, and then averages the result. While these methods work for 2 countries, the exchange rates may be inconsistent if applied to 3 countries, so further adjustment may be necessary so that the rate from currency A to B times the rate from B to C equals the rate from A to C.

Relative PPPbasket of goods, that is, many goods with different quantities. PPP then computes an inflation and exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location. For example, if a basket consisting of 1 computer, 1 ton of rice, and 1 ton of steel was 1800 US dollars in New York and the same goods cost 10800 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar.

The name purchasing power parity comes from the idea that, with the right exchange rate, consumers in every location will have the same purchasing power.

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the law of one price. So, ones traded easily and are commonly available in both locations. 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. Also, tariffs and difference in the price of labor (see Balassa–Samuelson theorem) can contribute to longer term differences between the two rates. One use of PPP is to predict longer term exchange rates.

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.

There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[2] A well-known purchasing power adjustment is the Geary–Khamis dollar (the international dollar). The World Bank's World Development Indicators 2005 estimated that in 2003, one Geary–Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[3]—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,965[4] while on a PPP basis it is about US$7,197.[5] At the other extreme, for instance Denmark's nominal GDP per capita is around US$53,242, but its PPP figure is US$46,602, in line with other developed nations.

There are variations to calculating PPP. The EKS method (developed by Ö. Éltető, P. Köves and B. Szulc) uses the geometric mean of the exchange rates computed for individual goods.[6] The EKS-S method (by Éltető, Köves, Szulc, and Sergeev) uses two different baskets, one for each country, and then averages the result. While these methods work for 2 countries, the exchange rates may be inconsistent if applied to 3 countries, so further adjustment may be necessary so that the rate from currency A to B times the rate from B to C equals the rate from A to C.

Relative PPP

Relative PPP is a weaker statement based on the law of one price, covering changes in the exchange rate and inflation rates. It seems to mirror the exchange rate closer than PPP does.[7]

Usage

Conversion

The global poverty line is a worldwide count of people

The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. PPP exchange rates include data from the sales of high end non-poverty related items which skews the value of food items and necessary goods which is 70 percent of poor peoples' consumption.[12] Angus Deaton argues that PPP indices need to be reweighted for use in poverty measurement; they need to be redefined to reflect local poverty measures, not global measures, weighing local food items and excluding luxury items that are not prevalent or are not of equal value in all localities.[13]

History

The idea originated with the The idea originated with the School of Salamanca in the 16th century, and was developed in its modern form by Gustav Cassel in 1916, in The Present Situation of the Foreign Trade.[14][15] While Gustav Cassel's use of PPP concept has been traditionally interpreted as his attempt to formulate a positive theory of exchange rate determination, the policy and theoretical context in which Cassel wrote about exchange rates suggests different interpretation. In the years immediately preceding the end of WWI and following it economists and politicians were involved in discussions on possible ways of restoring the gold standard, which would automatically restore the system of fixed exchange rates among participating nations. The stability of exchange rates was widely believed to be crucial for restoring the international trade and for its further stable and balanced growth. Nobody then was mentally prepared for the idea that flexible exchange rates determined by market forces do not necessarily cause chaos and instability in the peaceful time (and that is what the abandoning of the gold standard during the war was blamed for). Gustav Cassel was among those who supported the idea of restoring the gold standard, although with some alterations. The question, which Gustav Cassel tried to answer in his works written during that period, was not how exchange rates are determined in the free market, but rather how to determine the appropriate level at which exchange rates were to be fixed during the restoration of the system of fixed exchange rates. His recommendation was to fix exchange rates at the level corresponding to the PPP, as he believed that this would prevent trade imbalances between trading nations. Thus, PPP doctrine proposed by Cassel was not really a positive theory of exchange rate determination (as Cassel was perfectly aware of numerous factors that prevent exchange rates from stabilizing at PPP level if allowed to float), but rather a normative policy advice, formulated in the context of discussions on returning to the gold standard.[16]

ExamplesEach month, the Organisation for Economic Co-operation and Development (OECD) measures the differences in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed in each of the countries listed to buy the same representative basket of consumer goods and services that would cost US$100 in the United States.

According to the table, an American living or travelling in Switzerland on an income denominated in US dollars would find that country to be the most expensive of the group, having to spend 62% more US dollars to maintain a standard of living comparable to the US in terms of consumption.

Country Price level 2015
(US = 100)[17]
Australia 123
Austria 99
Belgium 101
Canada 105
Chile 67
Czech Republic 59
Denmark 128
Estonia 71
Finland 113
France 100
Germany 94 According to the table, an American living or travelling in Switzerland on an income denominated in US dollars would find that country to be the most expensive of the group, having to spend 62% more US dollars to maintain a standard of living comparable to the US in terms of consumption.

Since global PPP estimates—such as those provided by the ICP—are not calculated annually, but for a single year, PPP exchange rates for years other than the benchmark year need to be extrapolated.[18] One way of doing this is by using the country's GDP deflator. To calculate a country's PPP exchange rate in Geary–Khamis dollars for a particular year, the calculation proceeds in the following manner:[19]

Where PPPrateX,i is the PPP exchange rate of country X for year i, PPPrateX,b is the PPP exchange rate of country X for the benchmark year, PPPrateU,b is the PPP exchange rate of the United States (US) for the benchmark year (equal to 1), GDPdefX,i is the GDP deflator of country X for year i, GDPdefX,b is the GDP deflator of country X for the benchmark year, GDPdefU,i is the GDP deflator of the US for year i, and GDPdefU,b is the GDP deflator of the US for the benchmark year.

The bank UBS produces its "Prices and Earnings" report every 3 years. The 2012 report says, "Our reference basket of goods is based on European consumer habits and includes 122 positions".[20]

Educational

The Big Mac Index is a simple implementation of PPP where the basket contains a single good: a Big Mac burger from McDonald's restaurants. The index was created and popularized by The Economist as a way to teach economics and to identify over- and under-valued currencies.

The Big Mac has the value of being a relatively standardized consumer product that includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc.

There are some problems with the Big Mac Index. A Big Mac is perishable and not easily transported. That means the law of one price is not likely to keep prices the same in different locations. McDonald's restaurants are not present in every country, which limits the index's usage. Moreover, Big Macs are not sold at every McDonald's (noticeably in India), which limits its usage further.

In the white paper, "Burgernomics", the authors computed a correlation of 0.73 between the Big Mac Index's prices and prices calculated using the Penn World Tables. This single-good index captures most, but not all, of the effects captured by more professional (and more complex) PPP measurement.[7]

The Economist uses The Big Mac Index to identify overvalued and undervalued currencies. That is, ones where the Big Mac is expense or cheap, when measured using current exchange rates. The January 2019 article states that a Big Mac costs HK$20.00 in Hong Kong and US$5.58 in the United States.noticeably in India), which limits its usage further.

In the white paper, "Burgernomics", the authors computed a correlation of 0.73 between the Big Mac Index's prices and prices calculated using the Penn World Tables. This single-good index captures most, but not all, of the effects captured by more professional (and more complex) PPP measurement.[7]

The Economist uses The Big Mac Index to identify overvalued and undervalued currencies. That is, ones where the Big Mac is expense or cheap, when measured using current exchange rates. The January 2019 article states that a Big Mac costs HK$20.00 in Hong Kong and US$5.58 in the United States.[21] The implied PPP exchange rate is 3.58 HK$ per US$. The difference between this and the actual exchange rate of 7.83 suggests that the Hong Kong dollar is 54.2% undervalued. That is, it is cheaper to convert US dollars into HK$ and buy a Big Mac in Hong Kong than it is to buy a Big Mac directly in US dollars.

Similar to the Big Mac Index, the KFC Index measures PPP with a basket that contains a single item: a KFC Original 12/15 pc. bucket. The Big Mac Index cannot be used for most countries in Africa because most do not have a McDonald's restaurant. Thus, the KFC Index was created by Sagaci Research (a market research firm focusing solely on Africa) to identify over- and under-valued currencies in Africa.

For example, the average price of KFC's Original 12 pc. Bucket in the United States in January 2016 was $20.50; while in Namibia it was only $13.40 at market exchange rates. Therefore, the index states the Namibian dollar was undervalued by 33% at that time.

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