What Is Purchasing Power Parity? How PPP Works

Purchasing power is the value of a currency to be exchanged for goods and services. Purchasing power refers to the value of an individual unit of currency (in the case of the US, the value of a dollar) and what someone can buy with it. Inflation decreases a currency's purchasing power as the price of goods and services goes up.

Purchasing Power Parity (PPP) is a theory that compares the purchasing powers of currencies from different countries around the world. PPP theory aims to look at differing world economies as if they were on a single currency, creating parity between different world currencies. PPP can be used to determine how much more or less expensive it can be to live in another country.

Two countries are considered to have equal purchasing power parity if the cost of a basket of goods is the same in the two countries, once adjusted for exchange rates. Though institutions like the International Monetary Fund (IMF) look at PPP as an accurate measure of the comparative financial output of different countries, it doesn’t account for a few factors influencing the value of foreign currencies, like tariffs, market competition, and tax differences.

PPP was originally developed in 1968 by the International Comparisons Program, which was a collaboration between the United Nations and the University of Pennsylvania. They gathered statistical data about goods from a number of different countries to create an aggregate common currency, which could comparatively demonstrate the cost of living in a particular country. Here are some other reasons economists use PPP.

1. 1. To compare global GDPs. A common way of measuring a country’s economic growth is to look at its GDP (gross domestic product), which refers to the sum of a country’s economic output in a year. PPP is useful when comparing two countries' gross domestic product numbers, because it can help to adjust for the difference in the value of a single unit of currency from country to country.
2. 2. To measure a country’s economic health. Economists can consult PPP comparisons to understand the relative health of a country’s economy against other countries of similar global standing.
3. 3. To make economic predictions. Understanding the PPP between different countries enables economists to know which country has a stronger economy, despite the different values of different currencies. Both the IMF and the Organization for Economic Cooperation and Development (OECD) use PPP comparisons to make economic predictions and suggest relevant policy changes.

Some of the advantages of using PPP to compare the economies of different countries include the following things.

1. 1. PPP exchange rates are stable compared with the market. PPP exchange rates stay relatively stable when compared with financial world market rates. Comparing GDP using market rates can mean more volatility in comparisons, even when the individual countries' markets are stable.
2. 2. It accounts for non-traded goods. GDP measures a country’s economic productivity as it relates to the sale of tangible, internationally traded goods. However, PPP accounts for the cost of non-traded goods and services—like haircuts or massages—which also speaks to the productivity of a given economy.
3. 3. It provides real-world examples of living costs and standards. Every year, The Economist releases a comparative list of what 55 countries around the world charge for a McDonald’s Big Mac called the Big Mac Index. This example of PPP uses a recognizable good as a point of comparison between the living costs around the world, which is similar to the research of the ICP. Laypeople can look at the PPP of different goods in different places, and get a sense of how expensive or affordable their current home economy is.

Some of the potential disadvantages to using PPP when comparing the economies of different countries include the following.

1. 1. Taxes and tariffs are not accounted for. Different countries' sales taxes can alter prices of goods and services between states and countries, making a PPP comparison less precise. This also applies to transportation costs as well. Things like value-added tax can also affect the comparative value of currency.
2. 2. Market competition is not considered. Price levels between different goods in different financial markets may differ due to the competitiveness of that country’s demand for that commodity.
3. 3. Some countries are not accounted for in global comparisons. Every year, the ICP releases a new survey reporting on the PPP of 176 different countries. However, the ICP reports do not include every country around the world.

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