Purchasing Power Parity: What It Is and How to Calculate It

What Is Purchasing Power Parity?

PPP is an economic theory that compares the buying power of different currencies. According to this theory, exchange rates should eventually adjust so that identical goods cost the same in various countries. In other words, your money should buy you the same amount of goods or services, whether you are in Manchester or Mumbai.

The Theory Behind PPP

The basic idea is simple, if a basket of goods costs £100 in the UK and ₹90,000 in India, then according to PPP theory, the exchange rate should be £1 = ₹90. This is because the currencies should reflect the relative purchasing power in each country.

PPP comes from the ‘Law of One Price’. This law says that if there were no transport costs, taxes or trade barriers, the same product should sell for the same price everywhere after converting currencies.

If prices differ significantly, people could profit by buying goods in the cheaper country and selling them in the more expensive one – a process called arbitrage.

The Theory Behind PPP

There are two forms of PPP

Absolute PPP

Absolute PPP states that the price levels in two countries should be equal when expressed in the same currency. It gives a direct relationship between price levels and exchange rates. It is a simple and neat idea, but in reality, transport costs, tariffs and local market differences make it imperfect.

Relative PPP

Relative PPP focuses on changes over time, not exact equality. It states that the inflation rate varies across different countries and is reflected in exchange rates. Inflation is the rate at which prices for goods and services increase over time. If the prices increase, it means you buy less for more, hence the value of that currency is diminishing. For example, if prices rise faster in Mexico than in the UK, the Mexican peso is likely to weaken against the pound in the long run.

Relative PPP is considered more accurate because it reflects real-world economic behaviour.

How to Calculate PPP

The PPP equation is straightforward:

PPP Exchange Rate = Cost of Goods in Currency 1 ÷ Cost of Goods in Currency 2

A Practical Example

Let's say a loaf of bread with identical ingredients costs £2.50 in the UK and ₹200 in India. Using the PPP formula,

PPP Exchange Rate = £2.50 ÷ ₹200 = £0.0125 per rupee

Or vice-versa, ₹200 ÷ £2.50 = ₹80 per pound

This indicates that, based on bread prices alone, the PPP exchange rate should be ₹80 to £1.

The Big Mac Index

The Economist magazine created a famous real-world application called the Big Mac Index. McDonald's Big Macs are sold worldwide and their ingredients are more or less the same everywhere. Due to this, they make an excellent comparison tool. If a Big Mac costs £3.50 in London and ₹250 in Mumbai, the PPP exchange rate would be,

PPP Exchange Rate = ₹250 / £3.50 = approximately ₹71.43 per pound

Now, if the actual market exchange rate is ₹100 per pound, according to the PPP theory, this indicates that compared to the pound, the rupee’s value is lower. There are other geopolitical and macroeconomic factors contributing to this devaluation.

Limitations of PPP

Whilst PPP is useful, but not foolproof. Several factors can cause real exchange rates to differ from PPP predictions: