Purchasing power parity facts for kids

Purchasing power parity (PPP) helps us compare how much you can buy with your money in different countries. It looks at the price of the same things, like a basket of goods, in two different places. This helps us understand the true value of a country's currency.

PPP is different from the usual market exchange rate. This is because things like taxes on imports and other costs can change prices. PPP helps economists compare countries based on their gross domestic product (GDP), how productive their workers are, and how much people actually consume. It also helps compare the cost of living between places. To figure out PPP, experts use a "basket of goods" that includes thousands of items. These items range from consumer goods and services to equipment and construction projects.

What is Purchasing Power Parity?

Purchasing power parity is an economic idea that measures prices in different places. It is based on a simple rule called the "law of one price." This rule says that if there are no extra costs or trade barriers, a product should cost the same everywhere.

For example, imagine a computer costs 500 US dollars in New York. If the same computer costs 2,000 Hong Kong dollars in Hong Kong, PPP suggests the exchange rate should be 4 Hong Kong dollars for every 1 US dollar.

Things like poverty, taxes, and shipping costs make it hard for a single product to have the exact same price everywhere. So, PPP uses a "basket of goods" instead of just one item. This basket contains many different goods in various amounts.

PPP then calculates an exchange rate by comparing the price of this basket in one place to its price in another. For instance, if a basket with a computer, rice, and steel costs 1,000 US dollars in New York and 6,000 Hong Kong dollars in Hong Kong, the PPP exchange rate would be 6 Hong Kong dollars for every 1 US dollar.

The name purchasing power parity means that with the correct exchange rate, people in different countries should have the same ability to buy things.

The PPP exchange rate depends a lot on what items are chosen for the basket. Usually, items that are easily traded and common in both places are picked. Different groups that calculate PPP rates use different baskets, so their results can be slightly different.

The PPP exchange rate might not match the everyday market exchange rate. The market rate changes more often because it reacts to how much people want a currency. Also, taxes and different labor costs can cause long-term differences between the two rates. PPP is often used to guess what exchange rates might be like in the future.

Because PPP exchange rates are more stable and less affected by taxes, they are used for many international comparisons. For example, they help compare countries' GDPs or other national income numbers. These numbers are often called PPP-adjusted.

There can be big differences between incomes adjusted by PPP and those converted using market exchange rates. For example, in 2003, one special "Geary–Khamis dollar" (a PPP measure) was worth about 1.8 Chinese yuan. This was very different from the usual exchange rate. This difference is important. For instance, GDP per person in India is about US$1,965 using market rates. But with PPP, it is about US$7,197. This shows that people in India can buy more with their money locally than the market exchange rate suggests.

How PPP is Used

PPP exchange rates are useful when comparing a country's total production (GDP) and how much its people consume. They are important when the prices of goods that are not traded internationally matter. Market exchange rates are better for comparing individual goods that are traded between countries. PPP rates are more stable over time, which is helpful when consistency is important.

PPP rates help compare costs, but they do not include profits. They also do not consider the different quality of goods between countries. The same product might have different quality or safety levels in different countries. It can also have different taxes and shipping costs.

Market exchange rates change a lot. So, if you convert one country's GDP to another country's currency using market rates, it might look like one country is richer one year and poorer the next. This would not show the real picture of how much they produce.

If you convert a country's GDP using PPP exchange rates instead, this problem does not happen. PPP-measured GDP accounts for different costs of living and price levels, usually compared to the United States dollar. This gives a more accurate idea of how much a nation produces.

The exchange rate shows the value of traded goods between countries. It does not show the value of goods made and used only within a country. Also, currencies are traded for reasons other than buying goods and services. For example, people buy capital assets, whose prices change more than physical goods. Also, different interest rates, speculation, or actions by central banks can affect a country's purchasing power in international markets.

The PPP method helps correct for possible errors in statistics. The Penn World Table is a well-known source for PPP adjustments.

For example, if the value of the Mexican peso drops by half compared to the US dollar, Mexico's gross domestic product measured in dollars will also halve. But this exchange rate is from international trade and financial markets. It does not mean Mexicans are suddenly half as rich. If incomes and prices in pesos stay the same, they are not worse off, assuming imported goods are not vital.

Measuring income in different countries using PPP exchange rates helps avoid this problem. These numbers show how wealthy people are based on local goods and services. However, PPP is not good for measuring the cost of goods and services in international markets. This is because it does not show how much US$1 is worth in a specific country. In the example above, Mexicans can buy less internationally after their currency falls, even if their GDP PPP changes little.

Predicting Exchange Rates

PPP exchange rates are useful because market exchange rates tend to move in their general direction over many years. Knowing this can help predict which way an exchange rate might shift in the long run.

In economic theory, the purchasing power parity theory suggests that the exchange rate seen in international markets is the one used in PPP comparisons. This means the same amount of money should buy the same goods in either currency. This theory suggests that if a currency's purchasing power falls (prices go up), its value on the foreign exchange market should also drop.

Finding Manipulation

PPP exchange rates are especially helpful when governments artificially control official exchange rates. Some countries with strong government control make their currency seem stronger than it is. But the black market exchange rate for that currency might be artificially weak. In these cases, a PPP exchange rate is usually the most realistic way to compare economies. Also, when exchange rates move far from their normal level due to speculation, PPP offers a better way to compare.

In 2011, the Big Mac Index was used to show that Argentina might have been changing its inflation numbers.

Challenges with PPP

Calculating PPP exchange rates can be tricky. It is hard to find similar "baskets of goods" to compare purchasing power across countries.

Estimating PPP is complicated because countries do not just have one overall price difference. For example, food prices might be very different, while housing prices are less so, and entertainment prices are even more different. People in different countries also buy different things. It is hard to compare the cost of goods and services using a price index because what people buy and what is available changes from country to country.

So, adjustments are needed for differences in the quality of goods and services. Also, the basket of goods that represents one country's economy will be different from another's. For example, Americans eat more bread, while Chinese eat more rice. This means a PPP calculated using the US as a base will be different from one using China as a base. More problems come up when comparing more than two countries.

Different ways of averaging PPPs can make comparisons more stable, but they might make the comparisons between just two countries less accurate. These are common issues with any price index. Still, PPPs are generally strong despite the many problems that come with using market exchange rates for comparisons.

For example, in 2005, a gallon of gasoline cost US$0.91 in Saudi Arabia and US$6.27 in Norway. These big price differences would not make a PPP analysis accurate on their own. Many more comparisons need to be made and used in the overall PPP calculation.

When comparing PPP over time, it is important to account for inflation.

Besides the issues with choosing a basket of goods, PPP estimates can also vary based on how well countries collect statistics. The International Comparison Program (ICP), which PPP estimates are based on, needs countries to break down their national accounts into production, spending, or income. Not all countries regularly do this.

Some parts of PPP comparison are theoretically impossible or unclear. For example, there is no way to compare the Ethiopian worker who eats teff with the Thai worker who eats rice. This is because teff is not sold in Thailand, and rice is not sold in Ethiopia. So, you cannot find the price of rice in Ethiopia or teff in Thailand. Generally, the more similar the prices are between countries, the more accurate the PPP comparison.

PPP levels will also change based on the formula used to calculate prices. Each formula has its good and bad points.

Connecting different regions also creates problems. In 2005, the ICP compared regions using about 1,000 identical items. Prices for these items were found in 18 countries, with at least two countries in each region. While this was better than older methods, it might make poorer countries' PPP seem higher. This is because the price indexing gives more weight to goods consumed more in richer countries.

There are several reasons why different measures do not perfectly show the standard of living. In 2011, a spokesperson for the IMF said that GDP using PPP is not the best way to compare the size of countries in the global economy. This is because PPP prices are affected by services that are not traded internationally, which are more important locally than globally. The IMF believes that GDP at market rates is a better comparison.

Types of Goods and Services

The goods that money can buy for PPP are of different types:

• Local goods and services that are not traded internationally (like electricity). These are made and sold within the country.
• Tradable goods like non-perishable commodities that can be sold anywhere in the world (like diamonds).

The more a product is a local, non-tradable good, the more its price will be different from the usual exchange rate, moving closer to the PPP exchange rate. On the other hand, tradable products tend to have prices closer to the currency exchange rate.

More processed and expensive products are usually tradable. These will move away from the PPP exchange rate and closer to the currency exchange rate. Even if a country's currency has a PPP "value" three times stronger than its market exchange rate, it will not buy three times as much of internationally traded goods like steel, cars, and microchips. Instead, it will buy more non-traded goods like housing, services (like haircuts), and locally grown crops.

The difference in relative prices between tradable and non-tradable goods from rich to poor countries is due to the Balassa–Samuelson effect. This gives a big cost advantage to making tradable goods that require a lot of labor in low-income countries (like Ethiopia) compared to high-income countries (like Switzerland).

This cost advantage for companies simply means they have access to cheaper workers. But because these workers' pay goes further in low-income countries, the differences in pay between countries can last longer. This is another way of saying that wages are based on local productivity, which is lower than the productivity factories selling tradable goods internationally can achieve. A similar cost benefit comes from non-traded goods that can be bought locally. These act as a cheaper factor of production than what is available to factories in richer countries. It is hard for GDP PPP to consider the different quality of goods among countries.

Another idea, the Bhagwati–Kravis–Lipsey view, explains things differently from the Balassa–Samuelson theory. This view says that prices for non-tradable goods are lower in poorer countries because of differences in how much labor and capital they have, not because of lower productivity. Poor countries have more labor compared to capital. So, the extra output from one more worker is greater in rich countries than in poor countries. Non-tradable goods often require a lot of labor. Therefore, since labor is cheaper in poor countries and mostly used for non-tradables, non-tradables are cheaper there. Wages are high in rich countries, so non-tradables are relatively more expensive.

PPP calculations tend to focus too much on farming and not enough on manufacturing and services in a country's economy.

Trade Barriers and Non-Tradable Goods

The law of one price is weaker when there are shipping costs and government trade rules. These make it expensive to move goods between markets in different countries. Shipping costs break the link between exchange rates and prices. As shipping costs go up, exchange rates can change more widely. The same is true for official trade rules because customs fees affect importers' profits just like shipping fees. According to economists Krugman and Obstfeld, "Either type of trade barrier weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country." They give the example that a dollar in London should buy the same goods as a dollar in Chicago, which is clearly not true.

Non-tradable goods are mainly services and things made by the construction industry. Non-tradables also cause PPP to be different because their prices are not linked internationally. Their prices are set by local supply and demand. Changes in these can lead to differences in the price of a basket of goods compared to the same basket in another country. If the prices of non-tradables go up, the purchasing power of a currency in that country will fall.

Differences in Competition

Links between national price levels also weaken when trade barriers and markets that are not perfectly competitive exist together. "Pricing to market" happens when a company sells the same product for different prices in different markets. This shows differences in demand (e.g., almost no demand for pork in Islamic countries) and supply (e.g., whether there are few suppliers or many in a market). According to Krugman and Obstfeld, this product variation and separated markets lead to problems with the law of one price and absolute PPP. Over time, changes in market structure and demand can make relative PPP inaccurate.

Measuring Price Levels Differently

The way price levels are measured differs from country to country. Inflation data from different countries use different baskets of goods. So, exchange rate changes do not always cancel out official differences in inflation. Because it predicts price changes rather than price levels, relative PPP is still a useful idea. However, changes in the relative prices of items in the basket can cause relative PPP to fail tests based on official price indexes.

Global Poverty Line

The global poverty line counts people worldwide who live below an international poverty line, often called the "dollar-a-day" line. This line is 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 PPP exchange rates from the ICP. PPP exchange rates include data from sales of expensive, non-poverty-related items. This can make the value of food and necessary goods seem higher than they are for poor people, who spend 70 percent of their money on these items. Economist Angus Deaton argues that PPP indexes need to be reweighted for measuring poverty. They should reflect local poverty measures, not global ones, by weighing local food items and excluding luxury items not common or equally valued everywhere.

History of PPP

The idea of purchasing power parity first came from the School of Salamanca in the 1500s. It was developed into its modern form by Gustav Cassel in 1916. Cassel wrote about it in his book The Present Situation of the Foreign Trade.

Cassel's use of PPP has often been seen as his attempt to explain how exchange rates are set. However, the situation in which Cassel wrote suggests a different meaning. After World War I, economists and politicians discussed how to bring back the gold standard. This would automatically create a system of fixed exchange rates among countries.

Stable exchange rates were thought to be key to bringing back international trade and helping it grow steadily. People at that time were not ready for the idea that flexible exchange rates, set by markets, would not necessarily cause chaos in peaceful times. (The gold standard was abandoned during the war, and this was blamed for instability). Gustav Cassel was one of those who supported bringing back the gold standard, but with some changes.

The question Cassel tried to answer was not how exchange rates are set in a free market. Instead, he wanted to know what the right level for exchange rates should be when the fixed exchange rate system was restored.

He suggested fixing exchange rates at the PPP level. He believed this would prevent trade imbalances between countries. So, Cassel's PPP idea was not really a theory explaining how exchange rates work. (He knew many things could stop exchange rates from settling at the PPP level if they were allowed to float). Instead, it was advice on what policy to follow, given the discussions about returning to the gold standard.

Examples of PPP in Action

Comparing Prices with OECD

Every month, the Organisation for Economic Co-operation and Development (OECD) measures price differences between its member countries. They do this by comparing PPPs for household spending to exchange rates. The table below shows how many US dollars you would need in each country to buy the same basket of goods and services that would cost US$100 in the United States.

According to the table, if an American lived or traveled in Switzerland and earned US dollars, they would find Switzerland the most expensive. They would need to spend 27% more US dollars to have a similar lifestyle to the US in terms of what they buy.

Fun Ways to Understand PPP

To help people learn about PPP, the "basket of goods" is often made much simpler, sometimes using just one item.

The Big Mac Index

Big Macs, like this one from Japan, are similar worldwide.

The Big Mac Index is a simple way to show PPP. The "basket" here is just one item: a Big Mac burger from McDonald's. The Economist magazine created this index in 1986. It helps teach economics and shows which currencies might be overvalued or undervalued.

The Big Mac is a good choice because it is a fairly standard product. Its price includes costs from many parts of the local economy. These include farm products (beef, bread), labor, advertising, rent, and transportation.

However, there are some issues with the Big Mac Index. A Big Mac is perishable and cannot be easily moved. This means its price is not likely to be the same everywhere. Also, McDonald's restaurants are not in every country, and Big Macs are not sold at every McDonald's (for example, not in India). This limits its use.

In a report called "Burgernomics," researchers found a 0.73 correlation between the Big Mac Index prices and prices calculated using more complex methods. This shows that this simple index captures most of what professional PPP measurements do.

The Economist uses the Big Mac Index to find currencies that are overvalued or undervalued. This means currencies where the Big Mac is expensive or cheap when converted using current exchange rates. For example, in January 2019, a Big Mac cost HK$20.00 in Hong Kong and US$5.58 in the United States. The PPP exchange rate suggested by this is 3.58 HK$ per US$. The actual exchange rate was 7.83. This suggests the Hong Kong dollar was 54.2% undervalued. In other words, it was cheaper to change US dollars into Hong Kong dollars and buy a Big Mac in Hong Kong than to buy one directly in the US.

The KFC Index

Similar to the Big Mac Index, the KFC Index measures PPP using a single item: a KFC Original 12/15 piece bucket of chicken. The Big Mac Index cannot be used in most African countries because many do not have McDonald's. So, Sagaci Research, a company focused on Africa, created the KFC Index to find over- and undervalued currencies there.

For example, in January 2016, the average price of a KFC Original 12 pc. Bucket in the United States was $20.50. In Namibia, it was only $13.40 at market exchange rates. So, the index suggested the Namibian dollar was undervalued by 33% at that time.

The iPad Index

Like the Big Mac Index, the iPad index (created by CommSec) compares the price of an item in different places. However, unlike the Big Mac, every iPad (except for the model sold in Brazil) is made in the same place. All iPads of the same model also have the same features. So, price differences are due to shipping costs, taxes, and how much profit can be made in each market. In 2013, an iPad cost about twice as much in Argentina as in the United States.

PPP vs. CPI

Consumer price index (CPI) and purchasing power parity (PPP) are similar ideas. CPI measures how prices of goods and services change over time within one country. PPPs measure how prices change across different regions or countries.

See also

In Spanish: Paridad de poder adquisitivo para niños

• List of countries by GDP (PPP)
• List of countries by GDP (PPP) per capita
• List of IMF ranked countries by GDP, Includes IMF ranked PPP of 186 countries
• Measures of national income and output
• Relative purchasing power parity