Jump to:navigation,searchPPP of GDP for the countries of the world (2003). The US is the base country, so it is100. The highest index value, for Bermuda, is 154, so the same goods are 54% moreexpensive in Bermuda than in the United States.
purchasing power parity
) theory uses the long-termequilibriumexchange rateof two currencies to equalize theirpurchasing power. Developed byGustav Casselin 1920, it is based onthelaw of one price: the theory that, in an ideally efficient market,identical goods should have only one price. This purchasing power exchange rate equalizes the purchasing powerof differentcurrenciesin their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparingdifferences in living standards on the whole between nations becausePPP takes into account the relative
cost of living
ratesof different countries, rather than just a nominalgross domesticproduct(GDP) comparison. The best-known and most-used purchasingpower parity exchange rate is theGeary-Khamis dollar(the"international dollar").PPP exchange rates (the "real exchange rate") fluctuations are mostlydue to market exchange rates movements. Aside from this volatility,consistent deviations of the market and PPP exchange rates areobserved, for example (market exchange rate) prices of non-tradedgoods and services areusually lowerwhere incomes are lower. (AU.S.dollarexchanged and spent inIndiawill buy more haircuts than a dollarspent in theUnited States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In otherwords, PPP is the amount of a certain basket of basic goods which canbe bought in the given country with the money it produces. There can be marked differences between PPP and market exchangerates.
— muchdifferent than the nominal exchange rate that put one dollar equal to7.6 yuan. This discrepancy has large implications; for instance,GDPper capitain thePeople's Republic of Chinais aboutUS$1,800 while ona PPP basis it is about US$7,204. This is frequently used to assert thatChina is the world's second-largest economy, but such a calculationwould only be valid under the PPP theory. At the other extreme, Japan'snominal GDP per capita is around US$37,600, but its PPP figure is onlyUS$30,615.
PPP is: £P ($/£)= $P This implies that the exchange rate that equalizesthe value of a dollar of purchasing power (the PPP exchange rate) is:
If the actual spot rate is greater, it suggests that the £ is over-valuedagainst the $. If the actual spot rate is less, it suggests that the $ isover-valued against the £.For example if a "representative" consumption basket costs $1,500 inthe U.S. and £1,000 in the UK the PPP exchange rate would be $1.50/£.If the actual spot rate was $1.80/£ this would indicate that the pound isovervalued by 20%, or equivalently the dollar is undervalued by16.7%.
, which predicts the relationship between the twocountries' relative inflation rates and the change in the exchange rateof their currencies.Relative PPP relates theinflation rate(the change of price levels) ineach country to the change in the market exchange rate.,where
is thespot ratein Foreign Currency/Domestic Currency and
is the price level in period
(foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasingpower parity.According to this theory, the change in the exchange rate isdetermined by price level changes in both countries. For example, if prices in theUnited Statesrise by 3% and prices in theEuropean Unionrise by 1% the purchasing power of theUSDshould depreciate by 2%compared to the purchasing power of theEUR(equivalently theEURwill appreciate by about 2%)
The PPP exchange-rate calculation is controversial because of thedifficulties of finding comparablebaskets of goodsto comparepurchasing power across countries.Estimation of purchasing power parity is complicated by the fact thatcountries do not simply differ in a uniformprice level; rather, thedifference in food prices may be greater than the difference in housing