Purchasing Power Parity, How to Calculate PPP and How to Use It
Why Does a Big Mac Cost a Lot Less in China?
Purchasing power parity is a theoretical exchange rate that allows you to buy the same amount of goods and services in every country. It's a theoretical rate because no country actually uses it. But government agencies use it to compare the output of countries that use different exchange rates. You could use it to find out where to get the cheapest hamburger in the world.
The purchasing power parity calculation tells you how much things would cost if all countries used the U.S. dollar. In other words, it describes what anything bought throughout the world would cost if it were sold in the United States. The total of all those goods and services equals the country's economic output. Add the number produced in a year and you get the country's gross domestic product as measured by PPP.
Parity is tedious to compute. A U.S. dollar value must be assigned to everything. That includes items not widely available in America. For example, there aren't too many ox carts in the United States. Would its U.S. price accurately describe its value in rural Vietnam, where it's needed to grow rice? What is the U.S. price equivalent of a haircut in a country where family members are the barbers?
For many developing countries, the PPP is estimated using a multiple of the official exchange rate measure. For developed countries, the OER and PPP measures are more similar. Their standards of living are closer to that of the United States.
How to Use PPP
Which country has the world's largest economy? It would be easy to answer the question if all countries used the U.S. dollar. You would look up each country's economic output as measured by GDP. The country that produced the most would be No.1.
But all countries don't use the U.S. dollar. For example, China produced 127 trillion yuan's worth of goods and services in 2017. Using an exchange rate of 6.37 yuan per dollar, that's $11.97 trillion. The United States produced $19.36 trillion. But most of that difference is because the cost of living in China is much lower than in the United States. Since this method depends on exchange rates, China's GDP will change when its exchange rate changes.
So how do you compare their output? PPP recalculates a country's GDP as if it were being priced in the United States. The CIA World Factbook calculates PPP to compare output between countries. It estimated that China's 2017 GDP was $23.1 trillion. It's much more than the U.S. GDP of $19.4 trillion. According to PPP, China has the world's largest economy.
You could also use PPP to find out where you could get a McDonald's Big Mac for less. In 2018, the U.S. Big Mac cost $5.28. In China, you can get the same thing for only $3.17. The Economist's Big Mac Index reveals what a Big Mac costs in 48 countries.
The Big Mac is a good product to use to understand PPP.
Like most other sandwiches, the Big Mac doesn't travel well in its final form so it's not exported. Most of its price depends on local labor and restaurant rental costs. Since labor in China is cheaper, the Big Mac costs less than in the United States. The Big Mac Index will tell you a lot about a country's cost of living. If you want to live cheap, and you can move to any country in the world, use the Big Mac Index.
Thanks to McDonald's standards, a Big Mac is basically the same sandwich anywhere in the world. You aren't getting a smaller sandwich in China because it's almost $2 cheaper. Purchasing power parity solves this problem. It recalculates the value of a country's goods and services as if they were being sold at U.S. prices. Under PPP, a Chinese Big Mac costs $5.04, the same as it does in the United States.
Although it doesn't happen often, PPP is also used to set the exchange rate for new countries. It is also used to forecast future real exchange rates.
PPP was created after World War I. Before then, most countries relied on the gold standard. A country's exchange rate told you how much gold the currency was worth. Most countries abandoned the gold standard to pay for the war. They printed all the money they needed, creating inflation.
After the war, the Swedish economist Gustav Cassel suggested multiplying each currency's pre-war value by its inflation rate to get the new parity. That formed the basis for today's PPP.
Purchasing power parity is based on an economic theory that states the prices of goods and services should equalize between countries over time. International trade allows people to shop around for the best price. Given enough time, this comparison shopping allows everyone's purchasing power to reach parity or equalization.
Why We Don't Live in a PPP World
PPP depends on the law of one price. That states that once the difference in exchange rates is accounted for, then everything would cost the same.
That's not true in the real world for four reasons. First, there are differences in transportation costs, taxes, and tariffs. These costs will raise prices in a country. Countries with many trade agreements will have lower prices because they have fewer tariffs. Socialist countries will have higher costs because they have more taxes.
A second reason is that some things, like real estate and haircuts, can't be shipped. Only ultra-wealthy global travelers can compare the prices of homes in New York to those in London.
A third reason is that not everyone has the same access to international trade. For example, someone in rural China can't compare the prices of oxen sold throughout the world. But Amazon.com and other online retailers are providing more real purchasing power parity to even rural dwellers.
A fourth reason is that import costs are subject to exchange rate fluctuations. For example, when the U.S. dollar weakens, then Americans pay more for imports. The most significant driver of changing exchange rate values is the foreign exchange market. It creates wide swings in exchange rate values. For example, in 2014, many traders shorted the euro. The European Union's currency dropped. As a result, costs throughout the EU also fell. When traders began shorting the U.S. dollar in 2017, the dollar weakened.
The Bottom Line
The best way to understand PPP is to study the Big Mac Index. This index was created as a humorous attempt to illustrate how the PPP worked by comparing the prices of a globally sold product, the McDonald’s Big Mac burger. The Big Mac Index has been published in The Economist since 1986.
Calculating for purchasing power parity allows economists to determine the cost of living in other countries compared to the United States. PPP is a good tool for comparing GDP outputs between nations. It is also used to determine which have large or small economies. But since it involves many factors such as differences in taxes, tariffs, transportations costs, import costs, and the like, the PPP calculation is highly complex. This is best done by experts.