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In economics, purchasing power parity (PPP) is a number used to compare the standard of living of two countries. It is necessary because comparing the gross domestic products in a common currency does not accurately depict differences in material wealth. PPP, by contrast, takes into account both the differences in wages and the differences in cost-of-living. This is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices or in the opposite direction of the difference in entertainment prices. Moreover, purchasing patterns and even the goods available to purchase differ across countries, so that a constant basket of goods cannot be used to compare prices in different countries.

The differences between PPP and real exchange rates can be significant. For example, GDP per capita in China is ca. 1,400 US dollars (US$), while on a PPP basis, it is ca. 6,200 US$. At the other extreme, Japan's nominal GDP per capita is ca. 37,600 US$, but its PPP figure is only 31,400 US$.

## Explanation

PPP Spot exchange rates between the US and UK should be

S = P$/ P£ ($/£)

If the actual spot rate is > S, it would mean that the £ is over-valued and the $is undervalued, If the actual spot rate is < S, it would mean that the$ is over-valued and the £ is undervalued Eg.

S (per PPP) = 1.5 $/£ S (Actual spot rate) = 1.8$/£

This would indicate that PPP suggests, 1 £ should buy you only 1.5 $. However in the actual market you can buy 1.8$ (i.e. more $s) using 1 £. Thus, the £ is over-valued(i.e. the £ is giving you more$s, than is suggested by the PPP) vs. the $, OR the$ is under-valued vs. the £

## Method

The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.

A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US and GBP£3 in Britain, the PPP exchange rate would be £3 for$4. In the same way, if a Big Mac or any basket of goods costs USD$4 in the US, the PPP exchange rate is always GBP£3 for$4.

### Relative PPP

Relative PPP is concerned with change of price levels over different periods, also known as inflation rate. The equation looks like $\frac{S_t}{S_{t-1}}=\frac{P_{t}^*/P_{t-1}^*}{P_{t}/P_{t-1}}$, where St is the spot rate and Pt is the price in period t (foreign values are marked by an asterisk). The change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European union rise by 1% the PPP of the USD has to depreciate by 2% compared to the PPP of the EUR (or alternatively the EUR will appreciate by 2%).

### PPP equalization and the law of one price

The law of one price states that prices of traded goods will equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates.

The naïve PPP hypothesis is that free trade of goods should revert exchange rates to their PPP values. However, econometric analysis rejects this hypothesis, and gives a better prediction of the PPP/exchange rate relationship (the CPI) based on relative GDPs. Neo-classical economics includes Balassa-Samuelson effect theory, which explains the PPP model adjustment giving the equilibrium CPI.

For more discussion, see discussion and clarification of PPP.

## Application

A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to express these numbers in the same currency. Using actual exchange rates when making these comparisons can give a very misleading picture of living standards. The PPP method is used to as an alternative.

For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are any poorer; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

## Examples

### West and Central African Franc

During 2003 the US Dollar bought on average about 550 CFA franc. Because of a difference in the perceived "purchasing power parity" within some of the regions using the CFA franc, their purchasing power parity exchange rate differed like this (lower is stronger parity): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167.

### GDP of China

The CIA uses the purchase power parity method in its calculations of Gross National Product [1]. By this measure the People's Republic of China has the second largest economy in the world, at \$7.262 trillion (2004 est.) (CIA methodology for PPP).

## PPP: clarification and discussion

Main article: Discussion and clarification of PPP

The main reasons why PPP does not perfectly reflect standards of living are

• PPP numbers can vary with the specific basket of goods used, making it a rough estimate.
• Preferences and choices can vary from country to country. Goods then differ in their contribution to welfare.
• International competitiveness is mainly affected by the exchange rate and not by PPP.
• Differences in quality of goods are not sufficiently reflected in PPP.

PPP calculations are often used to measure poverty rates. For problems with this methodology, see How Not To Count The Poor.