Purchasing Power Parity & How to Calculate - What It Is, Theory, Example, & Equation

An Introduction to Purchasing Power Parity

Purchasing power parity (PPP) is a macroeconomic metric that allows users to compare and contrast standards of living between different countries. The theory takes a "basket of goods" approach where one chooses a list of items and compares the price of the whole "basket" in different countries to gauge the purchasing power of the local currency. 

By standardizing the goods and services in the imaginary "basket", we can build a theoretical exchange rate that sheds light on the standard of living one can expect to find in the country. A common example is instant noodles. If one is looking for an inexpensive cost of living, one can compare the price of local instant noodles across countries. 

PPP Methodology & Uses

The actual "basket" contains a calibrated collection of a wide range of products and services to enable us acquire a more accurate image devoid of biases, while an informal comparison of instant noodle pricing can offer you a peek of purchasing power parity.

Collecting this data and drawing comparisons based on it is a mammoth task that requires a small army of economists. In 1968, the United Nations established the International Comparison Program in concert with the University of Pennsylvania to help facilitate this endeavor. 

The Purchasing Power Parity values generated through the International Comparison Program help macroeconomists form estimates for global productivity and growth across the world. The World Bank releases a periodic report analyzing the productivity and growth of various countries in terms of USD and PPP. Even the International Monetary Fund and the Organization for Economic Cooperation and Development use PPP metrics to inform their economic predictions and policy recommendations. 

You may also find professionals in forex trading markets using PPP to determine if a currency is potentially overvalued or undervalued. Investors deeply integrated into foreign economies through equity or debt may also consider PPP to predict an impact on their investments through exchange-rate fluctuations. 

Relative PPP Formula

A relative version of PPP between two countries can be calculated as follows:

Relative PPP = G1 / G2

Where:

G1 = Cost of good X in currency 1

G2 = Cost of good X in currency 2

So, let's compare the prices of instant noodles in the imaginary countries of Dorst & Curta, whose currencies are the Dorst Dollar and Curta Penny, respectively:

In Dorst, a pack of instant noodles costs 10 Dorst Dollars (G1).

In Curta, a pack of instant noodles costs 3 Curta Pennies (G2).

We also know that 1 Curta Penny is worth 3.33 Dorst Dollars.

For the sake of convenience, let us convert both prices to Curta Pennies:

In Dorst, a pack of instant noodles costs 3.33 Curta Pennies (G1).

In Curta, a pack of instant noodles costs 3 Curta Pennies (G2).

Therefore, the purchasing power in Dorst relative to Curta is:

= G1 / G2

= 3.33 Curta Pennies / 3 Curta Pennies

= 3.33 / 3

= 1.11

The purchasing power in Dorst is 1.11 relative to Curta, showing us that Dorst is a bit more expensive to live in, as the relative value is greater than 1.

GDP by PPP vs Nominal GDP

A country's Gross Domestic Product (GDP) is an essential macroeconomic tool used to measure the growth of productivity in a country. It is the total monetary value of the goods and services produced within the country over a set period, usually one year.

However, since this number is highly dependent on monetary value, it needs to be adjusted for the various factors at play whenever money comes into the equation. The base number is called Nominal GDP, which is the total monetary value of all services and goods.

The Real GDP adjusts the Nominal GDP for inflation.

Similarly, a few enterprising economists worldwide have started adjusting the Nominal GDP for the PPP value. This adjustment allows them to compare the growth figures between countries with different currencies quickly. 

PPP vs CPI

Another macroeconomic calculation using the "basket of goods" approach is the Consumer Price Index (CPI). The CPI measures the differences in prices of the same goods and services over time within a single country. This gives economists an insight into the effects of inflation and other factors on the average consumer within the country. 

It differs from the PPP value because while CPI measures the differences in prices over time within a single region, the PPP measures the differences in prices across regions.

Impact of Inflation on PPP

Inflation is the natural, gradual increase in the prices of a broad range of products and services in a certain region. However, if inflation persists at a high level for an extended period, this can chip away at the purchasing power of the country's currency. 

Higher living expenses due to the currency's declining buying power affect people's ability to save. This is why investors look for assets that make a return higher than the current inflation rate, thereby protecting their portfolios against a drop in purchasing power. 

Keep In Mind

While PPP is a highly useful tool, one should bear in mind the following factors: 

Transportation Bias

Comparing the exact same goods may lead to a bias because if one of the countries is a producer of the goods while another is an importer, this biases the number towards the producer country as the other has to pay a higher cost to transport those goods into the country. 

Tax Differences

Similarly, governments have different tax structures for the same goods. For a country that produces a lot of technology, manufacturers of high-end technology may have tax subsidies leading to lower prices. In contrast, in other countries, high-end technology may be considered a luxury and, therefore, highly taxed. 

Cultural Differences

While some goods and services may be essential to life in one country, they may be niche items in another due to cultural differences. For example, the price of coffee in a country where coffee is essential may be lower than the cost of coffee in a country where tea drinkers form the majority of the population.