What Is Purchase Power Parity?

Purchase Power Parity Explained

Image shows a man buying food at a mcdonalds. Text reads: "What is purchasing power parity? A theoretical exchange rate that allows you to buy the same amount of goods and services in every country; Government agencies use it to compare the output of countries that use different exchange rates; Example: If you want to live cheap, and you can move to any country in the world, compare prices of a Big Mac"

Image by Miguel Co © The Balance 2019

Purchase power parity (PPP) is an economic theory that allows for the comparison of the purchasing power of various world currencies to one another. It is the theoretical exchange rate at which you can buy the same amount of goods and services with another currency.

Here, you'll learn why government agencies use PPP to compare national economies, and how you could use it to find out where to get the cheapest hamburger in the world.

Definition and Examples of Purchase Power Parity

The purchasing power parity calculation tells you how much things would cost if all countries used the same currency. In other words, it is the rate at which one currency would need to be exchanged to have the same purchasing power as another currency. Purchasing power parity is based on an economic theory that states the prices of goods and services should equalize among countries over time.

  • Acronym: PPP

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.

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. Also, it is doubtful that the cart's U.S. price would accurately describe its value in rural Vietnam, where it's needed to grow rice.

The World Bank computes PPP for each country in the world. It provides a map that shows the PPP ratio compared to the United States.

For many developing countries, the PPP is estimated using a multiple of the official exchange rate (OER) measure. For developed countries, the OER and PPP measures are more similar because the standards of living in developed countries are closer to those of the United States.

How Does Purchase Power Parity Work?

An economist will use the PPP to compare the economic output of different nations against one another. It might be used to determine which country has the world's largest economy. Using PPP exchange rates in addition to a country's gross domestic product (GDP) may help to provide a more detailed picture of a country's economic health.

The theoretical value is also helpful to traders in foreign currency and investors holding foreign stocks or bonds as it helps to predict fluctuations in international currency and indicate weakness.

Although it doesn't happen often, PPP is also used to set the exchange rate for new countries and forecast future real exchange rates.

Comparing a Country's Output

Purchasing power parity finds its greatest use in macroeconomic studies as you compare GDP. Since many countries have their own currency, GDP values can be skewed. 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 among countries. It is estimated that China's 2019 GDP was $22.5 trillion—much more than the U.S. GDP of $20.5 trillion. According to PPP, China has the world's largest economy.

However, without PPP, this comparison yields a different result. If you were to measure China's GDP in yuan, then simply convert that yuan to U.S. dollars at the market exchange rate, the country's 2019 GDP would only total roughly $14.3 trillion.

The difference between the two GDP measurements stems from the differences in the cost of living.

The Big Mac Index

You could also use PPP to find out where you could get a McDonald's Big Mac for less. In December 2020, the U.S. Big Mac cost $5.66. In China, you can get the same thing for 22.4 yuan. At current market exchange rates, that comes out to only $3.47. The Economist's Big Mac Index calculates these Big Mac comparisons for 55 countries.

The Big Mac Index is published each year by The Economist and was created in 1986.

Burgernomics—the study of the Big Mac index—can give an informal measure of the 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 less expensive, it costs less to produce one Big Mac than it does in the United States.

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, even though it's roughly $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.

The Big Mac Index will tell you a lot about a country's cost of living. If you want to live cheaply, and you can move to any country in the world, use the Big Mac Index.

History

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.

Why We Don't Live in a PPP World

PPP depends on the law of one price. In theory, once the difference in exchange rates is accounted for, then everything would cost the same.

This isn't the case 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 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. When traders decide to short a country's currency, they effectively reduce costs throughout that country.

Key Takeaways

  • Purchase power parity (PPP) is a method of accounting for differences in the cost of living when comparing national economies.
  • One way to understand PPP is to study the Big Mac Index, which compares the price of a McDonald's Big Mac in 55 countries.
  • PPP is a good tool for comparing GDP and relative economic size among nations.
  • Since it involves complex variables like tariffs and transportations costs, experts are typically the only ones that calculate the full PPP equation.