Definition of Purchasing Power Parity
Purchasing Power Parity (PPP) states that the currency of two countries is in equilibrium when the purchasing power in both countries is the same. To put it another way, the expenditure incurred in purchasing an item in two different countries must be the same. The concept of purchasing power is used globally to find the income levels of different countries.
Let us take an example for a better understanding of the concept.
Example of Purchasing Power Parity
Suppose the cost of jeans in India is Rs. 3000. Taking the dollar rate at Rs. 60/ per dollar. The same jeans in the US should cost $ 50. If the costs are identical for the same commodity in both countries, it is termed equilibrium in purchasing power parity.
An important question that may arise while learning about PPP is why this theory is relevant and significant to different countries. Let us try to understand the reason for the same.
Significance of Purchasing Power Parity
The World Bank gives a report every three years in which it compares the PPP and US $. This is done to find the growth and inflation rate of different countries. It gives a clear idea of the gap that exists between the rich and the poor. The study of PPP also indicates the inflation rate in the future. For example, if the inflation rate in Germany is 2% and the inflation rate in the US is 4%. In such a scenario, the US Dollar shall depreciate against the German Euro by 2% every year. This concept is very helpful when the inflation difference between two countries is significant.
Since we now know the significance of Purchasing Power Parity, let us understand how its calculation is done.
Calculation of Purchasing Power Parity
The easiest and most commonly used way to calculate the PPP is to measure and compare the price of a universal good that is identical in both countries. A universal product like a pen drive of 16 GB manufactured by HP can be taken. The only common problem while calculating the PPP of different countries is that different countries use a different set of goods and services. This makes comparison difficult. Also, the fact that each item has to be given a US dollar value, and that includes items that are not available in the US. This makes PPP calculation a tedious task. Also, visit Types of Foreign Exchange Exposure and International Financial Markets.
PPP reflects the cost of local goods and services in comparison to the United States. When GDP at PPP is taken, the derivation of purchasing power of citizens in a country can be done. The macro analysis of countries relies on different metrics like the cost of living, economic productivity, etc. One theory that significantly covers most of the important metrics is purchasing power parity. Going ahead, PPP shall continue to remain popular among economists for different calculations and predictions of different global economies of the world.
Also, read Interest Rate Parity.