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Encyclopedia > Purchasing power parity
PPP of GDP for the countries of the world (2003). The US is the base country, so it is 100. The highest index value, for Bermuda, is 154, so the same goods are 54% more expensive in Bermuda than the United States.
PPP of GDP for the countries of the world (2003). The US is the base country, so it is 100. The highest index value, for Bermuda, is 154, so the same goods are 54% more expensive in Bermuda than the United States.

The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the idea that, in an efficient market, identical goods must have only one price. Purchasing Power- the amount of value of a good/services compared to the amount paid. ... Karl Gustav Cassel (born October 20, 1866) was a Swedish economist and was Professor of Economics at the University of Stockholm, Sweden. ... The law of one price is an economic law stated as: In an efficient market all identical goods must have only one price. ...


A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. It is often used to compare the standards of living between countries, rather than a per-capita gross domestic products comparison at market exchange rates. The best known and most used purchasing power parity exchange rate is the Geary-Khamis dollar, also referred to as the international dollar. For exchange rates, see here. ... The standard of living refers to the quality and quantity of goods and services available to people and the way these services and goods are distributed within a population. ... GDP is an acronym which can stand for more than one thing: (in economics) an abbreviation for Gross Domestic Product. ... The Geary-Khamis dollar, also known as the international dollar is a sophisticated aggregation method for calculating economic comparisons between countries. ... The international dollar is a hypothetical unit of currency that has the same purchasing power that the U.S. dollar has in the United States at a given point in time. ...


Market exchange rates tend to fluctuate much more wildly than PPP exchange rates (the "Real Exchange Rate"). Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are usually lower where incomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. ... The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by GDP conversion at market exchange rates. ... USD redirects here. ...


There can be marked differences between PPP and market exchange rates. [1] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity [2] — much different than the nominal exchange rate that put one dollar equal to 7.6 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 used to assert that China is the world's second-largest economy, but such a calculation would only be valid 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. The World Bank logo The World Bank (the Bank) is a part of the World Bank Group (WBG), is a bank that makes loans to developing countries for development programs with the stated goal of reducing poverty. ... USD redirects here. ... CNY and RMB redirect here. ... Map of countries by GDP (nominal) per capita for the year 2006. ... USD redirects here. ...

Contents

Explanation

For a US dollar to buy as much in the UK as in the U.S., as is assumed under the law of one price, the price of a basket of goods in pounds in the UK (denoted as: £P) times the spot exchange rate (denoted as: $/£) should equal the price of the same basket in the U.S. priced in dollars (denoted as: $P). The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate (spot) settlement (payment and delivery). ...

£P ($/£)= $P

This implies that the exchange rate that equalizes the value of a dollar of purchasing power (the PPP exchange rate) is:

($/£)= $P/£P

If the actual spot rate is greater, it suggests that the £ is over-valued against the $. If the actual spot rate is less, it suggests that the $ is over-valued against the £.


For example if a "representative" consumption basket costs $1,500 in the U.S. and £1,000 in the UK the PPP exchange rate would be $1.50/£. If the actual spot rate was $1.80/£ this would indicate that the pound is overvalued by 20%, or equivalently the dollar is undervalued by 16.7%.


Relative PPP

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.


Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate.


frac{S_t}{S_{t-1}}=frac{P_{t}^*/P_{t-1}^*}{P_{t}/P_{t-1}},


where St is the spot rate in Foreign Currency/Domestic Currency and Pt is the price level in period t (foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasing power parity. The spot rate is the price of a contract for immediate delivery. ...


According to this theory, 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 purchasing power of the USD should depreciate by 2% compared to the purchasing power of the EUR (equivalently the EUR will appreciate by about 2%) USD redirects here. ... For other uses, see Euro (disambiguation). ... For other uses, see Euro (disambiguation). ...


PPP equalization and the law of one price

The law of one price states that differing prices of a traded good will tend to equalize in the absence of tariffs, other barriers to trade and prohibitively high shipping rates. The law of one price can also be stated as: "In an efficient market all identical goods must have only one price." The law of one price is an economic law stated as: In an efficient market all identical goods must have only one price. ... Tax rates around the world Tax revenue as % of GDP Economic policy Monetary policy Central bank   Money supply Fiscal policy Spending   Deficit   Debt Trade policy Tariff   Trade agreement Finance Financial market Financial market participants Corporate   Personal Public   Banking   Regulation        For other uses of this word, see tariff (disambiguation). ... A trade barrier is general term that describes any government policy or regulation that restricts international trade, the barriers can take many forms, including: Import duties Import licenses Export licenses Quotas Tariffs Subsidies Non-tariff barriers to trade Most trade barriers work on the same principle: the imposition of some... Damaged package The Panama canal. ... In finance, the efficient market hypothesis (EMH) asserts that stock prices are determined by a discounting process such that they equal the discounted value (present value) of expected future cash flows. ... In commerce, a product is a good economics and accounting good or service which can be bought and sold. ...


The PPP hypothesis is that free trade of goods will align exchange rates with 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 CPIs. Look up Hypothesis in Wiktionary, the free dictionary. ... In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. ... Econometrics literally means economic measurement. It is the branch of economics that applies statistical methods to the empirical study of economic theories and relationships. ... It has been suggested that this article be split into multiple articles accessible from a disambiguation page. ... The Balassa-Samuelson effect is either of two related things: The observation that consumer price levels in wealthier countries are systematically higher than in poorer ones (the Penn effect). An economic model predicting the above, based on the assumption that productivity or productivity growth-rates vary more by country in...


PPP measurement

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. The term market basket or commodity bundle refers to a specific type of basket, or a fixed list of items used specifically to track the progress of inflation in an economy or specific market. ...


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. The price level is a measurement of the average level of prices in an economy. ... This article does not cite its references or sources. ...


When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects. For the concept in cosmology, see cosmic inflation. ...


Big Mac Index

An entertaining example of one measure of 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 US$4 in the U.S. and GBP£3 in Britain, the PPP exchange rate would be £3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, tomatoes), labour (blue and white collar), advertising, rent and real estate costs, transportation, etc. The Big Mac Index is inaccurate in certain cases because of the different market conditions that exist in differing McDonald's locations. For instance, a Big Mac sold in downtown Chicago is likely to be priced higher than one the same product sold just miles away in Wisconsin. Such pricing differences existing in one country demonstrate the imperfection of the Big Mac Index. In addition, in some emerging economies western fast food represents an expensive niche product price well above the price of traditional staples - i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners. Although it is not perfect, the index still offers significant insight and an easy to understand example of PPP. McDonalds Big Mac purchased in Australia The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. ... The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd and edited in London. ... For other uses, see Big Mac (disambiguation). ... McDonalds Corporation (NYSE: MCD) is the worlds largest chain of fast-food restaurants[1]. Although McDonalds did not invent the hamburger or fast food, its name has become nearly synonymous with both. ... USD redirects here. ... GBP redirects here. ... This article is about the largest city of Illinois. ... This article is about the U.S. state. ... For other uses, see Big Mac (disambiguation). ...


iPod Index

The Australian securities firm CommSec introduced the iPod Index[1] as a light-hearted method of measuring PPP. Unlike the Big Mac, which is affected by local labour and transport costs, the iPod manufacturing costs are the same and the iPod is a tradeable commodity. The Commonwealth Bank of Australia (ASX: CBA), is the 2nd largest financial institution in Australia and number 41st in the world (according to Fortune Global 500) [5] with businesses in New Zealand, Asia and the United Kingdom. ... iPod is a brand of portable media players designed and marketed by Apple and launched in October 2001. ...


Also, this index may be invalid due to some degree of price discrimination on the part of Apple's marketing structure. Apple Inc. ...


West and Central African Franc

In 2003, the U.S. Dollar bought on average about 550 CFA franc. Because of a difference in purchasing power within some of the regions using the CFA franc, their purchasing power parity exchange rate differed greatly (lower implies a stronger currency): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167. now. ... now. ...


Need for PPP adjustments to GDP

Gross domestic product (by purchasing power parity) in 2006
Gross domestic product (by purchasing power parity) in 2006

Using market exchange rates to compare countries' standard of living or per capita Gross Domestic Product can give a very misleading picture. The exchange rate only reflects traded goods in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. Image File history File links Size of this preview: 800 × 351 pixelsFull resolution (1425 × 625 pixel, file size: 62 KB, MIME type: image/png)This bubble map shows the global distribution of gross domestic product (by purchasing power parity) in 2006 as a percentage of the top producer (USA - $13... Image File history File links Size of this preview: 800 × 351 pixelsFull resolution (1425 × 625 pixel, file size: 62 KB, MIME type: image/png)This bubble map shows the global distribution of gross domestic product (by purchasing power parity) in 2006 as a percentage of the top producer (USA - $13... The standard of living refers to the quality and quantity of goods and services available to people and the way these services and goods are distributed within a population. ... This article is about GDP in the context of economics. ... In accounting, a capital asset is an asset that is recorded as capital - that is, property that creates more property, e. ... An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ... Speculation involves the buying, holding, and selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. ... It has been suggested that this article or section be merged into Hedge (finance). ... The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. ...


The PPP method is used as an alternative.


For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican 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 half 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. ISO 4217 Code MXN User(s) Mexico Inflation 3. ... USD redirects here. ... This article is about GDP in the context of economics. ...


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.


Difficulties

The main reasons why different measures do not perfectly reflect standards of living are

  • PPP numbers can vary with the specific basket of goods used, making it a rough estimate.
  • 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. (For the New England grocery store chain, see: inflation in an economy. ... The poverty line is the level of income below which one cannot afford to purchase all the resources one requires to live. ...


Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

  1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
  2. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect). The word commodity has a different meaning in business than in Marxian political economy. ... This article is about the mineral. ... The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by GDP conversion at market exchange rates. ...


More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like China), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. This is sometimes called exploitation.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a relatively cheaper factor of production than is available to factories in richer countries. This page is a candidate to be moved to Wiktionary. ... The Balassa-Samuelson effect is either of two related things: The observation that consumer price levels in wealthier countries are systematically higher than in poorer ones (the Penn effect). An economic model predicting the above, based on the assumption that productivity or productivity growth-rates vary more by country in... Exploitation means many different things. ... In economics, business, and accounting, a cost is the value of inputs that have been used up to produce something, and hence are not available for use anymore. ... Classical economics distinguishes between three factors of production which are used in the production of goods: Land or natural resources - naturally-occurring goods such as soil and minerals. ...


PPP calculations tend to overemphasise the primary sectoral contribution and underemphasise the industrial and service sectoral contributions to the economy of a nation.


Difficulties with PPP comparisons in welfare economics

While using PPP exchange rates for income comparison is an improvement over using market exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another. The PPP method does not account for this. (This is not primarily a flaw in the exchange rate methodology, as cultural and interpersonal differences in utility functions are a more fundamental microeconomic problem.) Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution associated with it. ... Microeconomics is the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. ...


A PPP exchange rate varies depending on the choice of goods used for the index (CPI). Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. Indeed, it may be hard to construct equivalent representative bundles for the consumption habits of very different societies. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another, see: consumer price index. It has been suggested that this article be split into multiple articles accessible from a disambiguation page. ... It has been suggested that this article be split into multiple articles accessible from a disambiguation page. ...


Differing levels of government involvement in social spheres further complicate development of good CPI baskets (and, consequently, PPP measurements). For example, in 1986, nominal GDP of the United States was almost 4 times larger than the nominal GDP of the Soviet Union (on a per capita basis). Direct comparison failed to capture, however, that the Soviet Union provided free secondary and higher education and free healthcare to all its citizens, whereas Americans had to pay for education and healthcare themselves. To properly account for differences in quality of life in this situation, the CPI basket would have to include these expenditures explicitly. More importantly, government subsidies can potentially have large effect on consumption levels (free higher education will result in more college graduates), making it difficult to choose weights for individual components of CPI.


Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the standards of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Even a PPP-adjusted measure of GDP per capita must be used with caution, for all the usual reasons that the GDP figure itself is limited (for instance, its inability to capture the surplus between subjective value and payment price). This article is about mathematical mean. ... Surplus means the quantity left over, after conducting an activity; the quantity which has not been used up, and can refer to: budget surplus, the opposite of a budget deficit economic surplus Surplus product or surplus value in Marxian economics physical surplus in the economic theory of Piero Sraffa Operating...


For example, in 2002, the nominal GDP per capita in Japan was about US$40,000, while the equivalent PPP into a U.S. goods basket was estimated at $27,000. In the U.S., GDP per capita was about $36,400 (nominal and real if based on 2002 dollars). This means that the average U.S. citizen could enjoy slightly more consumption than the average Japanese (vastly more if private saving is removed from consumption income). However, it does not necessarily follow, that this implies a "higher standard of living" in the sense of "enjoying life" more; the U.S. has higher crime rates and less social cohesion than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences. Nominal generally derives from Name but it has specific meanings in the following areas: In economics a nominal value indicates the listed value of an item in a monetary currency as opposed to the real value in terms of purchasing power. ... For other uses of terms redirecting here, see US (disambiguation), USA (disambiguation), and United States (disambiguation) Motto In God We Trust(since 1956) (From Many, One; Latin, traditional) Anthem The Star-Spangled Banner Capital Washington, D.C. Largest city New York City National language English (de facto)1 Demonym American... Also see: 2002 (number). ... In economics, consumption refers to the final use of goods and services to provide utility. ... // This article does not cite any references or sources. ...


While per-capita income does not take into account inequalities in wealth distribution, neither does the PPP-scaled income.


Clarification to PPP Numbers of the IMF

The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that area's currency. The only time the PPP exchange rate and the market exchange rate can differ is when the GDP number is converted into another currency.


Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: [3]. The PPP exchange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.


References

  1. ^ http://www.comsec.com.au/public/news.aspx?id=809

See also

McDonalds Big Mac purchased in Australia The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. ... The international dollar is a hypothetical unit of currency that has the same purchasing power that the U.S. dollar has in the United States at a given point in time. ... There are three lists of countries of the world sorted by their gross domestic product (GDP) (the value of all final goods and services produced within a nation in a given year). ... Countries by nominal GDP. Source: IMF (2005) This article includes a list of countries of the world sorted by their gross domestic product (GDP), the value of all final goods and services produced within a nation in a given year. ... This article includes two lists of countries of the world[1] sorted by their gross domestic product (GDP) at purchasing power parity (PPP) per capita, the value of all final goods and services produced within a nation in a given year divided by the average population for the same year. ... Template:Push up GNP redirects here. ... The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by GDP conversion at market exchange rates. ... Karl Gustav Cassel (October 20, 1866 - January 14, 1945) was a Swedish economist and was Professor of Economics at the University of Stockholm, Sweden. ... The Geary-Khamis dollar, also known as the international dollar is a sophisticated aggregation method for calculating economic comparisons between countries. ... The international dollar is a hypothetical unit of currency that has the same purchasing power that the U.S. dollar has in the United States at a given point in time. ...

External links

  • Penn World Table
  • Explanations from the U. of British Columbia (also provides daily updated PPP charts)
  • OECD Purchasing Power Parity estimates updated annually by the Organization for Economic Co-Operation and Development (OECD)
  • World Bank International Comparison Project provides PPP estimates for a large number of countries
  • Union Bank of Switzerland's "Prices and Earnings" Report 2006Good report on purchasing power containing a Big Mac index as well as for staples such as bread and rice for 71 world cities.

  Results from FactBites:
 
Purchasing Power Parity - Best-Ranks.com (391 words)
Purchasing power parity is an economic technique used when attempting to determine the relative values of two currencies.
Purchasing power parity solves this problem by taking some international measure and determining the cost for that measure in each of the two currencies, then comparing that amount.
One of the primary uses of purchasing power parity is in lessening the misleading effects of shifts in a national currency.
  More results at FactBites »

 
 

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