What is Purchasing Power Parity (PPP)

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:

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 maybe there is a difference in both countries’ burger quality.

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.

PPP is closely linked to GDP because it helps determine the real value of economic output in different countries. When GDP is calculated using PPP-adjusted figures, it provides a more accurate description of the relative size of economies and their living standards. This is because PPP takes into account differences in price levels between countries, allowing for a more meaningful comparison of economic output.

In the case of India, using PPP-adjusted GDP figures can reveal a different ranking compared to nominal GDP rankings. India is a large and diverse country with significant variations in price levels across regions. PPP helps account for these differences, providing a more realistic assessment of India’s economic size and its purchasing power relative to other nations.

Moreover, PPP is often used to assess the “real” GDP growth rate, which adjusts for changes in price levels over time. This allows policymakers to make more informed decisions regarding economic policies and development strategies.

In summary, the relationship between PPP and GDP in India underscores the importance of using PPP-adjusted figures for international comparisons and understanding the country’s economic position in the global context.

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:

Assumption of Perfect Competition: PPP assumes that goods and services are perfectly tradable and 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.

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 are not fully captured by PPP.

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.

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.

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.

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.