Purchasing power parity (PPP) Facts
Purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920.
It is the method of using the long-run equilibrium exchange rate of two
currencies to equalize the currencies' purchasing power. It is based on the law
of one price, the idea that, in an efficient market, identical goods must have
only one price. Some PPP Facts here
Purchasing power parity is often called absolute purchasing power parity to
distinguish it from a related theory relative purchasing power parity, which
predicts the relationship between the two countries' relative inflation rates
and the change in the exchange rate of their currencies.
A purchasing power parity exchange rate equalizes the purchasing power of
different currencies in their home countries for a given basket of goods. These
special exchange rates are often used to compare the standards of living of two
or more countries. The adjustments are meant to give a better picture than
comparing gross domestic products (GDP) using market exchange rates. This type
of adjustment to an exchange rate is controversial because of the difficulties
of finding comparable baskets of goods to compare purchasing power across
countries.
Market exchange rates fluctuate widely, but many believe that PPP exchange rates
reflect the long run equilibrium value. The distortions caused by using market
rates are accentuated because prices of non-traded goods and services are
usually lower in poorer economies. For example, a U.S. dollar exchanged and
spent in the People's Republic of China will buy much more than a dollar spent
in the United States.
The differences between PPP and market exchange rates can be significant. For
example, the World Bank's World Development Indicators 2005 estimates that one
United States dollar is equivalent to approximately 1.8 Chinese yuan by
purchasing power parity in 2003. [1]. However, based on nominal exchange rates,
one U.S. dollar is currently equal to 7.9 yuan. This discrepancy has large
implications; for instance, GDP per capita in the People's Republic of China is
about US$1,800, while on a PPP basis it is about US$7,204. This is frequently
misused to assert that China is the world's second largest economy, but such a
calculation would be invalid under the PPP theory. At the other extreme, Japan's
nominal GDP per capita is around US$37,600, but its PPP figure is only
US$30,615.
Estimation of purchasing power parity 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, while also less
than the difference in entertainment prices. People in different countries
typically consume different baskets of goods. It is necessary to compare the
cost of baskets of goods and services using a price index. This is a difficult
task because purchasing patterns and even the goods available to purchase differ
across countries. Thus, it is necessary to make adjustments for differences in
the quality of goods and services. Additional statistical difficulties arise
with multilateral comparisons when (as is usually the case) more than two
countries are to be compared.
When PPP comparisons are to be made over some interval of time, proper account
needs to be made of inflationary effects.
