Purchasing power parity
Purchasing power parity is a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries' currencies. PPP is effectively the ratio of the price of a market basket 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 tariffs and other transaction costs.
The purchasing power parity indicator can be used to compare economies regarding their gross domestic product, labour productivity and actual individual consumption, and in some cases to analyse price convergence and to compare the cost of living between places. The calculation of the PPP, according to the OECD, is made through a basket of goods that contains a "final product list covers around 3,000 consumer goods and services, 30 occupations in government, 200 types of equipment goods and about 15 construction projects".
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. 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.This makes PPP similar to the consumer price index. Per Emeritus Professor DS Prasada Rao of the School of Economics, University of Queensland, "The CPI measures differences in levels of prices of goods and services over time within a country, whereas PPPs measure the change in levels of prices across regions within a country."
Poverty, tariffs, transportation, and other frictions prevent the 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 half a ton of steel was 1000 US dollars in New York and the same goods cost 6000 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. Thus, one attempts to select goods which are 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 differences in the price of labour 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, or are expressed in 'PPP' currencies, etc.
There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates. A well-known purchasing power adjustment is the Geary–Khamis 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—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 while on a PPP basis, it is about Int$7,197. At the other extreme, Denmark's nominal GDP per capita is around US$53,242, but its PPP figure is Int$46,602, in line with other developed nations.
Variations
There are variations in calculating PPP. The EKS method uses the geometric mean of the exchange rates computed for individual goods. The EKS-S method 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.Usage
Conversion
Purchasing power parity exchange rate is used when comparing national production and consumption and other places where the prices of non-traded goods are considered important.. PPP rates are more stable over time and can be used when that attribute is important.PPP exchange rates help costing but exclude profits and above all do not consider the different quality of goods among countries. The same product, for instance, can have a different level of quality and even safety in different countries, and may be subject to different taxes and transport costs. Since market exchange rates fluctuate substantially, when the GDP of one country measured in its own currency is converted to the other country's currency using market exchange rates, one country might be inferred to have higher real GDP than the other country in one year but lower in the other. Both of these inferences would fail to reflect the reality of their relative levels of production.
If one country's GDP is converted into the other country's currency using PPP exchange rates instead of observed market exchange rates, the false inference will not occur. Essentially GDP measured at PPP controls for the different costs of living and price levels, usually relative to the United States dollar, enabling a more accurate estimate of a nation's level of production.
The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the purchasing power parity of a country in the international markets.
PPP values try to correct statistical bias: the Penn World Table is a widely cited source of PPP adjustments; the associated Penn effect reflects such a systematic bias in using exchange rates to outputs among countries.
For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican 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 poorer by a half; 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, as the metrics give an understanding of relative wealth regarding local goods and services at domestic markets. On the other hand, it is poor for measuring the relative cost of goods and services in international markets. The reason is it does not take into account how much US$1 stands for in a respective country. Using the above-mentioned example: in an international market, Mexicans can buy less than Americans after the fall of their currency, though their GDP PPP hardly changed.
Exchange rate prediction
PPP exchange rates are never valued because market exchange rates tend to move in their general direction, over a period of years. There is some value to knowing in which direction the exchange rate is more likely to shift over the long run.In neoclassical economic theory, the purchasing power parity theory assumes that the exchange rate between two currencies actually observed in the different international markets is the one that is used in the purchasing power parity comparisons, so that the same amount of goods could actually be purchased in either currency with the same beginning amount of funds. Depending on the particular theory, purchasing power parity is assumed to hold either in the long run or, more strongly, in the short run. Theories that invoke purchasing power parity assume that in some circumstances a fall in either currency's purchasing power would lead to a proportional decrease in that currency's valuation on the foreign exchange market.
Identifying manipulation
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison. Similarly, when exchange rates deviate significantly from their long term equilibrium due to speculative attacks or carry trade, a PPP exchange rate offers a better alternative for comparison.In 2011, the Big Mac Index was used to identify manipulation of inflation numbers by Argentina.