What Is Purchasing Power Parity? How It Impacts the Economy

Have you ever wondered where your money goes when travelling to different countries? “Purchasing Power Parity” is essential for understanding how money works worldwide.

In simple terms, PPP helps us compare the value of money between different places. This blog will help you understand purchasing power parity, its calculation, and its various types.

What is Purchasing Power Parity?

Purchasing Power Parity (PPP) is an economic concept that helps us compare the relative value of currencies between different countries. In simpler words, it’s like a yardstick we use to see if a certain amount of money has the same purchasing power in two different places.

If we use PPP to compare the value of the Indian Rupee to the US Dollar, it helps us understand if the purchasing power of money remains the same when you move from India to the US. This comparison allows economists and policymakers to determine how strong currencies are compared to each other and to understand whether stuff costs more or less in different countries.

Types of Purchasing Power Parity

There are different types of PPP, but the two most commonly discussed are:

Absolute Purchasing Power Parity

This theory suggests that exchange rates between currencies should equalise the prices of the same goods and services in different countries when expressed in the same currency.

Relative Purchasing Power Parity

This idea takes inflation into account and says that if one country’s prices go up faster than another’s, the exchange rate will change to balance things out over time.

Case Study on PPP

To better understand PPP, economists often use indices like:

1. The Big Mac Index

It’s like a global burger test! Economists look at how much a Big Mac costs in different countries. If it is pricier in one country compared to another, it might mean that the country’s currency is stronger, or there may be a difference in both countries’ burger quality.

2. KFC Index

Then, there’s the KFC Index, which is similar but uses the price of a KFC meal instead of a Big Mac. So, if a KFC meal is cheaper in India than in the US, it could suggest that the Indian Rupee is weaker compared to the US Dollar.

How to calculate PPP: the PPP Formula

Calculating Purchasing Power Parity (PPP) involves comparing the prices of goods between different countries while considering currency exchange rates. The formula for PPP is:

PPP = (Price of goods in country A/Price of same goods in country B) * Exchange Rate

Let’s break this down with an example using Indian Rupees (INR) and US Dollars (USD):

Suppose a basket of goods costs 1000 INR in India, and the same basket costs USD 20 in the United States. If the exchange rate is 1 USD = 83 INR, we can calculate the PPP as follows:

PPP = (1000 INR/20 USD) * 83

PPP  = 4150 INR/USD

The PPP in this example is 4150 INR/USD. According to the PPP, 1 USD should have the same purchasing power as 4150 INR when comparing the cost of goods between India and the United States.

Essentially, PPP helps us see if currencies are overvalued or undervalued compared to each other based on what you can buy with them in different countries.

If the actual exchange rate in the market differs significantly from this PPP rate, it indicates whether a currency is undervalued or overvalued.

For instance, if the market exchange rate is less than 4150 INR/USD, the Indian rupee is undervalued compared to the US dollar, according to PPP. Conversely, if the market exchange rate is more than 4150 INR/USD, it indicates that the Indian Rupee is overvalued compared to the US Dollar according to PPP.

So, to determine if a currency is undervalued or overvalued, you would compare the market exchange rate to the PPP rate calculated based on the relative prices of goods and services between the two countries.

What is the relationship between PPP and GDP?

The relationship between Purchasing Power Parity (PPP) and Gross Domestic Product (GDP) in India is crucial for understanding the country’s economic standing and comparing it with other nations.

Understanding PPP and GDP

Purchasing Power Parity (PPP) is closely linked to Gross Domestic Product (GDP) as it helps determine the real value of economic output in different countries. By adjusting GDP using PPP, we get a more accurate representation of an economy’s relative size and living standards.

Importance of PPP-Adjusted GDP

• PPP accounts for differences in price levels between countries.
• It allows for a meaningful comparison of economic output.
• Helps in assessing the actual purchasing power of a nation’s currency.

India’s Economic Position with PPP-Adjusted GDP

• India’s ranking changes when GDP is measured using PPP instead of nominal GDP.
• Significant price variations across regions make PPP a better indicator of real economic size.
• It provides a more realistic assessment of India’s purchasing power relative to other nations.

Role of PPP in Real GDP Growth

• PPP is used to evaluate “real” GDP growth by adjusting for price level changes over time.
• It helps policymakers make informed economic decisions and development strategies.

The relationship between PPP and GDP in India highlights the importance of PPP-adjusted figures for international comparisons. It offers a clearer understanding of India’s economic position on the global stage.

Impact of Purchasing Power Parity (PPP) on Indian Stock Market Volatility

Purchasing Power Parity (PPP) and the volatility of Indian stock market are interconnected through inflation, exchange rate fluctuations, and foreign investment flows. As PPP implies that exchange rates adjust based on differences in inflation between countries, a depreciating Indian Rupee (INR) can affect corporate earnings, specifically for importers and exporters. Which, in turn, affects investor sentiment and stock prices. 

Impact of PPP on Foreign Institutional Investors (FIIs)

Foreign institutional investors (FIIs) play a key role in India’s stock market, often reacting to exchange rate movements caused by PPP adjustments. A weakening INR may lead to capital outflows, boosting market volatility. High inflation influences PPP and can prompt the RBI to adjust interest rates, impacting stock valuations and investor confidence. 

Therefore, while Purchasing Power Parity (PPP) and stock market volatility may not have a direct correlation, the economic factors influenced by PPP significantly contribute to market fluctuations in India.

Understanding Stock Market Volatility

Volatility is the rate at which the price of a security decreases or increases for a given set of returns. It suggests the risk associated with the changing price of the security and is estimated by calculating the standard deviation of the annualized returns over a given time. 

In simpler terms, volatility measures how quickly the value of securities or market indexes moves. The meaning of volatility in stock market context is the rapid price fluctuation in either direction. Thus, a high standard deviation value represents prices can dynamically rise or fall. In most cases, a surge or dip of 1% in market indexes classifies it as a “volatile” market. 

Limitations of Purchasing Power Parity

While Purchasing Power Parity (PPP) is a valuable tool for comparing the relative value of currencies and understanding international price levels, it does have some limitations:

1. Assumption of Perfect Competition

PPP assumes that goods and services are perfectly tradable and that there are no barriers to trade. In reality, factors like transportation costs and trade restrictions can distort price levels and undermine the accuracy of PPP calculations.

2. Non-Traded Goods

PPP primarily focuses on tradable goods and services, but it may not accurately reflect the prices of non-tradable goods such as housing, healthcare, and education. These sectors often have significant price differences between countries, which PPP does not fully capture.

3. Quality Differences

PPP does not account for differences in the quality of goods and services between countries. Even if prices for similar items seem equal after adjusting for exchange rates, the quality and features of those items may vary significantly.

4. Price Indices Accuracy

PPP calculations rely on accurate price indices, which may not always be available or reliable, especially in developing countries where data collection can be challenging.

5. Short-term Fluctuations

PPP is more suitable for long-term analysis rather than short-term fluctuations. In the short term, exchange rates can be influenced by factors like speculation, investor sentiment, and political events, leading to deviations from PPP values.

6. Assumption of Market Efficiency

PPP assumes that markets are efficient and prices adjust quickly to reflect changes in exchange rates. However, in reality, markets may be slow to adjust, leading to temporary deviations from PPP.

Despite these limitations, PPP remains a valuable tool for understanding relative price levels between countries and assessing the purchasing power of currencies in the global economy.

Conclusion

Purchasing Power Parity helps us see how currencies stack up against each other in the global marketplace. By understanding PPP, we gain insights into international trade, investment decisions, and economic policies.