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

How PPP Works and Why It Matters?

Because the International Comparison Program (ICP) of the USA theoretically began with noodle prices, this represents a simplistic view of the methodology used in PPP.

In reality, an extensive array of goods and services is required to create a "basket" for the formal calculation of PPPs. This is so that any potential distortion or bias in the results that accrue from gathering all that data can be eliminated.

A worldwide collaborative effort is needed to obtain this data. As such, in 1968, the United Nations created the International Comparison Program (ICP) in conjunction with the University of Pennsylvania to collect, coordinate, and standardise the prices of goods and services on a global level.

The economic evaluation process is dependent on the use of various types of PPP metrics. The International Monetary Fund (IMF), World Bank, and Organisation for Economic Cooperation and Development (OECD), for example, use PPP to calculate both the current and predicted levels of global economic activity and productivity.

The World Bank periodically publishes a series of global comparisons of individual countries, such as GDP levels, by the U.S. dollar and by PPP dollar value, which helps to form international development goals for these nations and guide their economic development strategies.

Similarly, PPP metrics are incorporated into the economic forecasts and policy recommendations made by the IMF's and the OECD's technical assistance programs. PPP metrics are also relevant to finance and capital markets.

In particular, when a foreign exchange trader is attempting to determine whether a particular currency is over- or undervalued, they will often use PPP as a measure of value or guide.

In addition, many investors will use PPP value as a guide when investing in foreign countries, especially when they anticipate that exchange rate fluctuations will influence their investment returns.

Example

The relative version of PPP helps illustrate how purchasing power compares across two economies. It is calculated using the formula:

Relative PPP = G1/G2

where G1 is the price for the same good sold in country one and G2 is the price for the same good sold in country two.

Let's say that we create two fictional countries, Dorst and Curta. Dorst sells a pack of instant noodles for 10 Dorst dollars, and Curta sells the same pack for 3 Curta pennies, with an exchange rate of 1 Curta penny = 3.33 Dorst dollars. The price in Dorst is then equivalent to 3.33 Curta pennies.

When we plug these prices into the formula, we get:

3.33/3 = 1.11

With a relative PPP of 1.11, it implies that it costs slightly more to live in a country like Dorst compared to Curta.

PPP vs GDP

In the same way that PPP is interconnected with GDP, GDP measures the entirety of goods and services produced by a nation during a particular calendar year. Nominal GDP represents this total dollar quantity but does not reflect the effects of inflation or currency exchange rates.

As such, economists utilize PPP adjustments to evaluate the actual production levels of nations. In addition to enabling more precise comparisons of economies based upon productivity, GDP-adjusted for inflation also provides a means by which the relative competitiveness of different nations can be assessed based upon their GDP relative to other nations.

When evaluating a developing country's GDP in terms of the total economic output, it may be discounted from some perspectives due to the potential for a lower value placed on their less-developed currencies compared to more developed economies.

Therefore, the use of GDP-adjusted-for-inflation allows for more accurate comparisons between nations and provides a mechanism for quantifying the relative capabilities of both domestic and international economies in terms of their ability to compete against one another.

PPP vs. CPI

Many people confuse PPP and the Consumer Price Index (CPI), which is another major Index that uses a basket of goods as its methodology. However, the two indices serve different functions.

Whereas CPI shows you how prices are changing through time for one specific country, to identify trends in inflation and purchasing power with respect to domestic consumers, PPP allows you to compare prices for a given good or service in different countries and determine the relative standard of living across them.