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Myers' Psychology for AP2nd EditionDavid G Myers 900 solutions Myers' Psychology for the AP Course3rd EditionC. Nathan DeWall, David G Myers 955 solutions One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach, not to be confused with the Paycheck Protection Program created by the CARES Act. Image by Sabrina Jiang © Investopedia 2020According to this concept, two currencies are in equilibrium—known as the currencies being at par—when a basket of goods is priced the same in both countries, taking into account the exchange rates. Key Takeaways
Click Play to Learn How to Calculate Purchasing Power ParityCalculating Purchasing Power ParityThe relative version of PPP is calculated with the following formula: S = P 1 P 2 where: S = Exchange rate of currency 1 to currency 2 P 1 = Cost of good X in currency 1 \begin{aligned} &S=\frac{P_1}{P_2}\\ &\textbf{where:}\\ &S=\text{ Exchange rate of currency }1\text{ to currency }2\\ &P_1=\text{ Cost of good }X\text{ in currency }1\\ &P_2=\text{ Cost of good }X\text{ in currency }2 \end{aligned} S=P2P1where:S= Exchange rate of currency 1 to currency 2P1= Cost of good X in currency 1 Comparing Nations' Purchasing Power ParityTo make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. However, this one-to-one comparison is difficult to achieve due to the sheer amount of data that must be collected and the complexity of the comparisons that must be drawn. To help facilitate this comparison, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP) in 1968. With this program, the PPPs generated by the ICP have a basis from a worldwide price survey that compares the prices of hundreds of various goods and services. The program helps international macroeconomists estimate global productivity and growth. Every few years, the World Bank releases a report that compares the productivity and growth of various countries in terms of PPP and U.S. dollars. Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use weights based on PPP metrics to make predictions and recommend economic policy. The recommended economic policies can have an immediate short-term impact on financial markets. Also, some forex traders use PPP to find potentially overvalued or undervalued currencies. Investors who hold stock or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment. Pairing Purchasing Power Parity With Gross Domestic ProductIn contemporary macroeconomics, gross domestic product (GDP) refers to the total monetary value of the goods and services produced within one country. Nominal GDP calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal gross domestic product for inflation. However, some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies. To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5. In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro. GDP by Purchasing Power Parity vs Nominal GDP Drawbacks of Purchasing Power ParitySince 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac hamburger across many countries. Their study results in the famed "Big Mac Index". In "Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality. Transport CostsGoods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods. Tax DifferencesGovernment sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another. Government InterventionTariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper. Non-Traded ServicesThe Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally. Market CompetitionGoods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high. The Bottom LineWhile it's not a perfect measurement metric, purchase power parity does allow for the possibility of comparing pricing between countries that have differing currencies. What is purchasing power parity used for?The other approach uses the purchasing power parity (PPP) exchange rate—the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country.
How does GDP compare to PPP?To compare the data, each country's statistics must be converted into a common currency. The two most common methods to convert GDP into a common currency are nominal and purchasing power parity (PPP).
How does PPP compare to countries?One way to reach comparable (or equalized) values of goods and services between the countries is to apply the PPP exchange rate in the conversion. The PPP exchange rate is that exchange rate that would equalize the value of comparable market baskets of goods and services between two countries.
What is GDP measured at PPP?PPP GDP is gross domestic product converted to international dollars using purchasing power parity rates. An international dollar has the same purchasing power over GDP as the U.S. dollar has in the United States.
What are the two forms of purchasing power parity?There are two forms of the Purchasing Power Parity: absolute and relative. where is the FX rate, is the price level in the home country, and is the price level in the foreign country.
What is purchasing power parity in Indian economy?Purchasing power parities (PPPs) are the rates of currency conversion that try to equalise the purchasing power of different currencies, by eliminating the differences in price levels between countries.
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Purchasing power parity is used to compare the gross domestic product between
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