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 an economic theory that states 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.
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 three reasons. First, there are differences in transportation costs, taxes, and tariffs. These costs will increase 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 comparison shop homes in New York versus London.
A third reasons is that not everyone has the same access to international trade. For example, someone in rural China can't price shop books. Perhaps one day Amazon.com and other online retailers will enable real purchasing power parity.
A fourth potential 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 can create 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 opposite occurred.
The purchasing power parity calculation determines how much things would cost if parity did exist. It describes what each item purchased in a country would cost if it were sold in the United States. These are then added up for all the final goods and services produced in that country for that given year.
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 give it?
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 of the gross domestic product are more similar. Their standards of living are closer to the United States.
How It's Used
The PPP calculation is needed because each country reports its economic output in its own currency. 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 you cannot compare the two without taking into account the fact that the cost of living in China is much lower than in the United States.
In January 2018, a McDonald's Big Mac costs $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. It's a good product to evaluate PPP because it doesn't transport well in its final form. A lot of its local price depends on labor and restaurant rental costs. Low labor costs make the sandwich cheaper in China than in the United States.
Purchasing power parity solves the problem of comparing countries with different standards of living. 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.
Under PPP, China's GDP in 2017 was $23.12 trillion. That makes it the world's largest economy, ahead of the European Union and the United States. That's why the Central Intelligence Agency provides GDP estimates on both an official exchange rate and a purchasing power parity basis.
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.