Purchasing Power Parity

How Is Purchasing Power Parity (PPP) Calculated and What Does It Mean? Purchasing power parity is a well-liked macroeconomic study metric to contrast economic productivity and living standards between nations (PPP). PPP, which is not to be confused with the Paycheck Protection Program established by the CARES Act, is an economic theory that contrasts the currencies of various nations using a "basket of goods" approach. 

 

When a basket of items is priced the same in both nations while accounting for exchange rates, two currencies are said to be in equilibrium, or to be at par. 

 

•    Macroeconomic experts frequently use the purchasing power parity (PPP) statistic to compare the currencies of various nations using a "basket of goods" method.

 

•    Economists can compare economic production and living standards across nations thanks to purchasing power parity (PPP).

 

•    In order to account for PPP, some nations modify their GDP estimates.

 

The following formula is used to determine the relative version of PPP:

 

S= p1\p2

Where,

S= Exchange rate of currency 1 to 2 

P1=Cost of good x in currency 1

P2=Cost of good x in currency 2

 

A wide range of commodities and services must be taken into account in order to meaningfully compare costs between nations. Due to the enormous amount of data that must be gathered and the intricacy of the comparisons that must be made, it is challenging to conduct a one-to-one comparison. The International Comparison Program (ICP), which was founded in 1968 by the University of Pennsylvania and the United Nations, was created to aid in this comparison.

 

The PPPs produced by the ICP using this tool are supported by a global price survey that compares the costs of hundreds of different commodities and services. The tool assists global macroeconomists in estimating productivity and growth on a worldwide scale. The World Bank publishes a report every few years that compares the productivity and growth of various nations in PPP and US dollars.

 

Weights based on PPP measurements are used by the International Monetary Fund (IMF) and Organization for Economic Cooperation and Development (OECD) to forecast the future and suggest economic policies.

 

Financial markets may experience an immediate short-term impact as a result of the suggested economic reforms.

 

PPP is also used by certain forex traders to identify either overvalued or undervalued currencies. The survey's PPP numbers can be used by investors who own foreign company stock or bonds to forecast how exchange rate movements would affect a nation's GDP and, in turn, their investment. 

 

Gross domestic product (GDP) is the term used in modern macroeconomics to describe the entire monetary worth of the products and services generated within a single nation. The monetary value is computed using nominal GDP in current, absolute terms. The nominal gross domestic product is adjusted for inflation using real GDP.

 

However, some accounting goes one step farther and accounts for PPP value in GDP adjustment. This adjustment aims to change nominal GDP into a figure that is simpler to compare across nations and currencies. Consider a scenario in which a shirt costs $10 in the United States and €8.00 in Germany to better understand how GDP and purchase power parity interact. In order to compare like with like, we must first convert the €8.00 to US dollars. 

 

The PPP would be 15/10, or 1.5, if the shirt in Germany cost $15.00 due to the exchange rate.

 

In other words, the same shirt costs $1.50 in Germany when purchased with the euro compared to $1.00 in the United States. 

 

Comparisons of nominal GDP might be misleading because currencies can be changed. A more equitable comparison between nations can be made using GDP by PPP, which is based on a basket of goods. 

 

The price of a Big Mac hamburger sold by McDonald's Corp. (MCD) in numerous nations has been amusingly recorded by The Economist since 1986. Their research yields the renowned "Big Mac Index." The following reasons were mentioned by writers Michael R. Pakko and Patricia S. Pollard in "Burgernomics," a well-known 2003 work that examines the Big Mac Index and PPP, as to why the purchasing power parity theory is not a good representation of reality. 

 

Locally unavailable goods must be imported, which adds to the expense of transportation. These expenses cover import taxes in addition to fuel. Therefore, imported items will command a somewhat higher price than comparable domestically sourced ones. 

 

Value-added taxes (VAT) and other government sales taxes have the potential to drive up costs in one nation relative to another.

 

Tariffs can significantly increase the cost of imported goods, even if the same items would often be cheaper elsewhere.

 

The pricing of the Big Mac includes non-traded ingredient costs. These considerations cover things like labor costs, utility bills, and insurance. Therefore, it is doubtful that such costs will be comparable internationally.

 

Products may be purposefully priced higher in a nation. Higher prices can reflect a business's potential advantage over other vendors in the marketplace. The business could be a monopoly or a member of a cartel of businesses that influence pricing to keep them high.

 

Purchase power parity does allow for the possibility of price comparison between nations with various currencies, even though it is not a perfect measurement metric.