Purchasing power parity - Wikipedia, the free encyclopedia

Purchasing power parity
From Wikipedia, the free encyclopedia

Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power.[1] It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries. Among other uses, PPP rates facilitate international comparisons of income, as market exchange rates are often volatile, are affected by political and financial factors that do not lead to immediate changes in income and tend to systematically understate the standard of living in poor countries, due to the Balassa–Samuelson effect. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918.[2][3] The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.[4] Another interpretation is that the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.

GDP per capita adjusted for purchasing power parity (PPP) in the world, 2007

Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP-adjusted" and converted into common units. The best-known purchasing power adjustment is the Geary–Khamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the Balassa– Samuelson theorem. There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[5] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[6]—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,704.063[7] while on a PPP basis it is about US$3,608.196.[8] At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is US$37,304.

Purchasing power parity adjustment for the world (2003). The economy of the United States is used as a reference and is set at 100. Bermuda has the highest index value at 154; this means that goods sold there are more over priced than in the US.

1 Measurement 1.1 Relationship between PPP and law of one price 1.2 Big Mac Index 1.3 Starbucks tall latte index 1.4 OECD comparative price levels 1.5 Measurement issues 2 Need for PPP adjustments to GDP 3 Difficulties 3.1 Range and quality of goods 3.2 Trade barriers and nontradables 3.3 Departures from free competition 3.4 Differences in consumption patterns and price level measurement 4 PPP and global poverty line 5 See also 6 Notes 7 External links

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.[citation needed]
en.wikipedia.org/wiki/Purchasing_power_parity 1/7

en. during which time both a Big Mac and tall latte cost $2. Thus. however.91 US. People in different countries typically consume different baskets of goods. If the law of one price is not true for a certain commodity. rent and real estate costs. The tall latte index was compiled in 2004. the price levels will not differ enough from the level predicted by PPP. This can be explained by a number of factors: transportation costs and government [4][10] Furthermore. cheese). lettuce. Furthermore. some argue that the law of one price does not need to be true exactly for PPP to be valid. but the dollar prices of Big Macs are actually different in from Japan. Nevertheless. Various ways of averaging bilateral PPPs can provide a more stabile multilateral comparison. The measures told the same story in most cases with the notable exception of Asia. the yen was 12% undervalued against the dollar. Countries like Argentina that have abundant beef resources see a structural underpricing in the Big Mac. but at the cost of distorting bilateral ones. different countries. The Big Mac Index is presumably useful because it is based on a well-known food whose final price. like this one This index provides a test of the law of one price.org/wiki/Purchasing_power_parity 2/7 . Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. rather. according to the Starbucks tall latte index and the Big Mac index.[11] The following table.9/7/12 Purchasing power parity . Big Mac hamburgers. More comparisons have to be made and used as variables in the overall formulation of the PPP. PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons.[9] The significant differences in price wouldn't contribute to accuracy in a PPP analysis. shows the under (-) and over (+) valuation of the local currency against the dollar in %. For example. are similar worldwide. the Big Mac is not a mainstream 'cheap' meal as it is in the West. bread. based on data from The Economist's 2004 calculations. but a luxury import for the middle classes and foreigners. transportation. It is necessary to compare the cost of baskets of goods and services using a price index.Wikipedia. Relationship between PPP and law of one price Although it may seem as if PPP and the law of one price are the same. which underlies purchasing power parity. popularized by The Economist.80.[4] The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent. when discussing the validity of PPP. the Chinese yuan was 56% undervalued based on the Big Mac index but neither significantly undervalued nor overvalued according to the Starbucks index.e. Chinese more rice. When PPP comparisons are to be made over some interval of time. which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. labor (blue and white collar). western fast food represents an expensive niche product price well above the price of traditional staples—i. Big Mac Index Main article: Big Mac Index An example of one measure of law of one price. such as agricultural commodities (beef. the basket of goods representative of one economy will vary from that of another.27 US. According to the Big Mac index. Starbucks tall latte index The Starbucks tall latte index is a variant of the Big Mac Index. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. in some emerging regulations. the difference in food prices may be greater than the difference in housing prices. etc. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. product differentiation. it is necessary to make adjustments for differences in the quality of goods and services. despite all of the variables that contribute to the significant differences in price. is the Big Mac Index. Americans eat more bread. whereas it was 13% overvalued according to the tall latte index. easily tracked in many countries.wikipedia. the index should give a guide to the direction in which currencies should move. it can give information regarding exchange rates similar to the Big Mac Index. the free encyclopedia Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in an uniform price level. This relates back to the idea of product differentiation: few substitutes for the Big Mac allows McDonald's to have market power. in 2005 the price of a gallon of gasoline in Saudi Arabia was $0. as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Furthermore. while also less than the difference in entertainment prices. proper account needs to be made of inflationary effects. includes input costs from a wide range of sectors in the local economy. and prices of nonfood inputs. there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. By determining whether a currency is undervalued or overvalued. If the law of one price is true for all commodities then PPP is also therefore true. and in Norway the price was $6. economies. advertising. These are all general issues of indexing.

org/wiki/Purchasing_power_parity 3/7 . the free encyclopedia Country Australia Canada China Eurozone Hong Kong Japan Malaysia Mexico New Zealand Singapore South Korea Switzerland Taiwan Thailand Turkey Starbucks tall latte index -4 -16 -1 +33 +15 +13 -25 -15 -12 +2 +6 +62 -5 -31 +6 McDonald's Big Mac Index -17 +23 -16 -56 +24 -45 -12 -53 -21 -4 -31 0 +82 -21 -46 +5 United Kingdom +17 OECD comparative price levels Each month. According to the table. in each of the countries listed to buy the same representative basket of consumer goods and services that would cost 100 USD in the United States. en. having to spend 74% more US dollars to maintain a standard of living comparable to the USA in terms of consumption.9/7/12 Purchasing power parity . as of June 2012.Wikipedia. the Organisation for Economic Co-operation and Development measures the difference in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. an American living in Switzerland on an income denominated in US dollars would find that country (in June 2012) to be one of the most expensive in world. The OECD table below indicates the number of US dollars needed.wikipedia.

it may serve to overstate the PPP basis of poorer countries. and the superlative method. The International Comparison Program. there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice. IDB. which is not fully take into account differing quality between goods. PPP estimates can also vary based on the statistical capacity of participating countries. As a general rule. which PPP estimates are based on. Geary-Khamis.000 identical items for which a price could be found for 18 countries.wikipedia. Each has advantages and disadvantages. expenditure or (in some cases) income. because teff is not commercially available in Thailand and rice is not in Ethiopia.Wikipedia. For example. the more valid the PPP comparison. the free encyclopedia Country Australia Austria Belgium Canada Chile Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Israel Italy Japan Korea Luxembourg Mexico Netherlands New Zealand Norway Poland Portugal Slovenia Spain Sweden Switzerland Turkey United States Price level (USA = 100)[12] 157 111 117 127 73 149 84 127 115 107 100 70 118 125 117 99 149 80 124 64 111 126 160 59 99 90 103 128 174 56 100 Czech Republic 80 Slovak Republic 76 United Kingdom 132 Measurement issues In addition to methodological issues presented by the selection of a basket of goods. Some aspects of PPP comparison are theoretically impossible or unclear. because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries. require the disaggregation of national accounts into production. so the price of rice in Ethiopia or teff in Thailand cannot be determined. Different possible formulas include GEKS-Fisher. selected so that at least two countries would be in each region. In the 2005 ICP round. regions were compared by using a list of some 1. PPP levels will also vary based on the formula used to calculate price matrices. en. the more similar the price structure between countries.9/7/12 Purchasing power parity . and not all participating countries routinely disaggregate their data into such categories. Linking regions presents another methodological difficulty.org/wiki/Purchasing_power_parity 4/7 . While this was superior to earlier "bridging" methods.

Conversely. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate. goods produced for home-country use. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. (See also Penn effect). so nontradables are relatively more expensive. services ("haircuts"). therefore. The PPP method is used as an alternative to correct for possible statistical bias. category 2 products tend to trade close to the currency exchange rate. PPP exchange rates for years other than the benchmark year need to be updated.org/wiki/Purchasing_power_parity 5/7 .b is the PPP exchange rate of country X for the benchmark year. hedging or interventions by central banks can influence the foreignexchange market. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. this exchange rate results from international trade and financial markets.b is the GDP deflator of country X for the benchmark year. falling into the second category. However. non-tradable goods and services (like electric power) that are produced and sold domestically. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. Nontradables tend to be labor-intensive. because labor is less expensive in poor countries and is used mostly for nontradables. GDPdefX.b is the PPP exchange rate of the United States (US) for the benchmark year (equal to 1).g. it won't buy three times as much of internationally traded goods like steel. By contrast. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia). Wages are high in rich countries. as against high income countries (like Switzerland). moving towards the PPP exchange rate. GDPdefU.wikipedia. the currency's black market exchange rate is artificially weak. if the value of the Mexican peso falls by half compared to the US dollar. PPPrateU.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPPexchange rate than the nominal exchange rate in which receipts are paid).Wikipedia. and drifting from the PPP exchange rate to the currency exchange rate. so marginal productivity of labor is greater in rich countries than in poor countries. a PPP exchange rate is likely the most realistic basis for economic comparison. GDPdefX.i is the GDP deflator of country X for year i. the free encyclopedia Need for PPP adjustments to GDP The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods. Tradable goods such as non-perishable commodities that can be sold on the international market (like diamonds). the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. but non-traded goods like housing. the Mexican Gross Domestic Product measured in dollars will also halve. Since global PPP estimates —such as those provided by the ICP— are not calculated annually. Measuring income in different countries using PPP exchange rates helps to avoid this problem. different interest rates. The more that a product falls into category 1. but because the pay of those workers goes farther in lowincome countries than high. Also. These act as a cheaper factor of production than is available to factories in richer countries. speculation.i is the PPP exchange rate of country X for year i. cars and microchips.b is the GDP deflator of the US for the benchmark year. currencies are traded for purposes other than trade in goods and services. and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. nontradables are cheaper in poor countries. In the case of calculating the PPP exchange rate of a country's currency in Geary–Khamis dollars for a particular year. the calculation is as follows: Where PPPrateX. The corporate cost advantage is nothing more sophisticated than access to cheaper workers. if incomes and prices measured in pesos stay the same. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital. This is done using the country's GDP deflator. to buy capital assets whose prices vary more than those of physical goods.[4] en. PPPrateX. Local. Difficulties There are a number of reasons that different measures do not perfectly reflect standards of living. It does not necessarily mean that Mexicans are poorer by a half. The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the Balassa-Samuelson theory. Range and quality of goods The goods that the currency has the "power" to purchase are a basket of goods of different types: 1. and domestically produced crops.. In such cases. Poor countries have more labor relative to capital.9/7/12 Purchasing power parity . they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. that is. Gross domestic product (by purchasing power parity) in 2006 For example. not because of lower levels of productivity. Also.i is the GDP deflator of the US for year i. 2. and GDPdefU. More processed and expensive products are likely to be tradable. but around once every five to ten years. The Penn World Table is a widely cited source of PPP adjustments. e. the more that its price will be from the currency exchange rate.

relative PPP is still a useful concept.org/wiki/Purchasing_power_parity 6/7 . 942. therefore. However. ^ FT.g. I. University of British Columbia. In Reinert. which make it expensive to move goods between markets located in different countries.org/stable/2223329) . accessed June 27.[4] Departures from free competition Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. This is a reflection of inter-country differences in conditions on both the demand side (e. "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price. this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP.9/7/12 Purchasing power parity . The prices are determined by domestic supply and demand. The Economic Journal.[4] Differences in consumption patterns and price level measurement Measurement of price levels differ from country to country. 2012. Overtime. which may invalidate relative PPP.Wikipedia. which is certainly not the case.. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. exchange rate changes do not offset official measures of inflation differences. See also Big Mac Index International dollar Relative purchasing power parity List of cities by GDP List of countries by GDP (PPP) List of countries by GDP (PPP) per capita List of countries by future GDP (PPP) estimates List of countries by future GDP (PPP) per capita estimates Measures of national income and output Penn effect Karl Gustav Cassel Geary-Khamis dollar Notes 1. 3.sauder. Kenneth A.. According to Krugman and Obstfeld. No. Because it makes predictions about price changes rather than price levels. whether the existing market for a prospective entrant's product features few suppliers or instead is already near-saturated). This line represents an average of the national poverty lines of the world's poorest countries.ubc. International Economics. referred to as the dollar-a-day line. "purchasing power parity" (http://books. ^ Cheung. Princeton: Princeton University Press. the underlying mechanism behind PPP. the free encyclopedia PPP calculations tend to overemphasise the primary sectoral contribution. Pearson Education. p. If the prices of nontradables rise. ^ Purchasing Power Parity (http://fx. Retrieved 2 October 2011. India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04 en. JSTOR 2223329 (http://www."[4] They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes. Gustav (December 1918). virtually no demand for pork or alcohol in Islamic states) and the supply side (e. ISBN 978-0-691-12812-2.com/books?id=BnEDno1hTegC&pg=PA942) .China. and underemphasise the industrial and service sectoral contributions to the economy of a nation. The Princeton Encyclopedia of the World Economy. is weakened by transport costs and governmental trade restrictions. Ramkishen S. 413–415.. Rajan.google. As transport costs increase.html) . the larger the range of exchange rate fluctuations. http://books. Trade barriers and nontradables The law of one price. 2. Pricing to market occurs when a firm sells the same product for different prices in different markets. and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. expressed in international dollars. Yin-Wong (2009). 4.wikipedia. ^ a b c d e f g h Krugman and Obstfeld (2009). Inflation data from different countries are based on different commodity baskets. Glass.. According to Krugman and Obstfeld. 28. ^ Cassel.. Nontradables also lead to deviations in PPP because the prices of nontradables are not linked internationally. 5. Inc. the purchasing power of any given currency will fall in that country.google. shifts in market structure and demand will occur.com/books?id=BnEDno1hTegC&pg=PA942. pp. 112.com / World .ca/PPP. Nontradables are primarily services and the output of the construction industry. Abnormal Deviations in International Exchanges. Amy Jocelyn et al.g.jstor..[4] PPP and global poverty line The global poverty line is a worldwide count of people who live below an international poverty line.

upenn.eu/statistics_explained/index.ec.econ.com) .pdf) provides an overview of methodological issues in calculating PPP and in designing the ICP under which the main PPP tables (Maddison..9/7/12 Purchasing power parity .oecd. Jamal Ibrahim.php/Purchasing_power_parities_as_example_of_international_statistical_cooperation) from Eurostat . Inc. http://www.Statistics Explained World Bank International Comparison Project (http://www.ubc.wikipedia.repec.com/node/2361072.aspx?DataSetCode=CPL) OECD August 2.eurostat. a non-profit organization.com/pf/features/lists/global_gasprices/) CNN Money (http://money. 12.ft. 2012 6. vol. Retrieved 30 August 2011.7 | Relative prices and exchange rates (http://devdata. "Burgers or beans? A new theory is percolating through the foreign-exchange markets"" (http://www. the free encyclopedia (http://www.upenn. Wikipedia® is a registered trademark of the Wikimedia Foundation." (March 2005) (http://money.sauder. en. See Terms of use for details.cnn. “Currency Valuation and Purchasing Power Parity (http://ideas.Wikipedia. Penn World Tables. 2011.com/1/ShowMedia/ubs_ch/wealth_mgmt_ch?contentId=103982&name=eng. 8. 12(3).org/wdi2005/Table5_7.cnn.econ.worldbank.economist.europa. Accessed June 2011.com/node/2361072) . additional terms may apply. ^ Haidar.html) (also provides daily updated PPP charts) OECD Purchasing Power Parity estimates (http://www. and World Bank WDI) are based Retrieved from "http://en.edu/) Explanations from the U.pdf) Good report on purchasing power containing a Big Mac index as well as for staples such as bread and rice for 71 world cities.org/Index.org/std/ppp) updated annually by the Organization for Economic Co-Operation and Development (OECD) Purchasing power parities as example of international statistical cooperation (http://epp.org/wiki/Purchasing_power_parity 7/7 . September 11.oecd. 10.org/a/wej/wldecn/479.worldbank.ubs. pages 1-12. of British Columbia (http://fx. 7. "Understanding PPPs and PPP based national accounts" (http://pwt. ^ "The Starbucks index.org/data/icp) provides PPP estimates for a large number of countries UBS's "Prices and Earnings" Report 2006 (http://www.” World Economics – The Oxford Institute for Economic Policy.wikipedia.org/w/index. The Economist.php?title=Purchasing_power_parity&oldid=511022277" Categories: Economic indicators Index numbers International economics Gross domestic product This page was last modified on 6 September 2012 at 04:47. Jan 15 2004.com/cms/s/0/36a2d566-ad82-11dc-9386-0000779fd2ac.ca/PPP.economist. Text is available under the Creative Commons Attribution-ShareAlike License.edu/papers/deaton%20heston%20complete%20nov10. External links Penn World Table (http://pwt. ^ [1] (http://stats.html) ^ 2005 World Development Indicators: Table 5.htm) ^ List of countries by past and future GDP (nominal) ^ List of countries by future GDP (PPP) per capita estimates ^ "Global Gas Prices. 9.html) .