INTERNATIONAL FINANCE

MANAGEMENT

PURCHASING POWER PARITY

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Table of Contents :-

1. History
2. PPP Theory
3. Calculation of PPP
4. Use of PPP
5. Explaination of PPP
6. Different Yardsticks
7. Advantages & Drwabacks
8. Bottom Line
9. References

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History
PPP was created after World War I. Before then, most countries relied on the gold standard.
A country's exchange rate told you how much gold the currency was worth. Most countries
abandoned the gold standard to pay for the war. They printed all the money they needed,
creating inflation.
After the war, the Swedish economist Gustav Cassel suggested multiplying each currency's
pre-war value by its inflation rate to get the new parity. That formed the basis for today's
PPP.
PPP Theory
Purchasing power parity is based on an economic theory that states the prices of goods and
services should equalize between countries over time. International trade allows people to
shop around for the best price. Given enough time, this comparison shopping allows
everyone's purchasing power to reach parity or equalization.

What are Purchasing Power Parity (PPPs)?

Definition: The theory aims to determine the adjustments needed to be made in the
exchange rates of two currencies to make them at par with the purchasing power of each
other. In other words, the expenditure on a similar commodity must be same in both
currencies when accounted for exchange rate. The purchasing power of each currency is
determined in the process.
Description: Purchasing power parity is used worldwide to compare the income levels in
different countries. PPP thus makes it easy to understand and interpret the data of each
country.

Purchasing power parity is a theoretical exchange rate that allows you to buy the same
amount of goods and services in every country. It's a theoretical rate because no country
actually uses it. But government agencies use it to compare the output of countries that use
different exchange rates. You could use it to find out where to get the cheapest hamburger
in the world.
PPPs are the rates of currency conversion that equalize the purchasing power of different
currencies by eliminating the differences in price levels between countries. In their simplest
form, PPPs are simply price relatives that show the ratio of the prices in national currencies
of the same good or service in different countries. PPPs are also calculated for product
groups and for each of the various levels of aggregation up to and including GDP.

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Example: Let's say that a pair of shoes costs Rs 2500 in India. Then it should cost $50 in
America when the exchange rate is 50 between the dollar and the rupee.

How PPPs are calculated?

The purchasing power parity calculation tells you how much things would cost if all countries
used the U.S. dollar. In other words, it describes what anything bought throughout the world
would cost if it were sold in the United States. The total of all those goods and services
equals the country's economic output. Add the number produced in a year and you get the
country's gross domestic product as measured by PPP.

Parity is tedious to compute. A U.S. dollar value must be assigned to everything. That
includes items not widely available in America. For example, there aren't too many ox carts
in the United States. Would its U.S. price accurately describe its value in rural Vietnam,
where it's needed to grow rice? What is the U.S. price equivalent of a haircut in a country
where family members are the barbers?
The World Bank computes PPP for each country in the world. It provides a map that shows
the PPP ratio compared to the United States.
For many developing countries, the PPP is estimated using a multiple of the official exchange
rate measure. For developed countries, the OER and PPP measures are more similar. Their
standards of living are closer to that of the United States.
The calculation is undertaken in three stages :-
1. The first stage is at the product level, where price relatives are calculated for
individual goods and services. A simple example would be a litre of Coca-Cola. If it
costs 2.3 euros in France and 2.00$ in the United States then the PPP for Coca-Cola
between France and the USA is 2.3/2.00, or 1.15. This means that for every dollar
spent on a litre of Coca-Cola in the USA, 1.15 euros would have to be spent in France
to obtain the same quantity and quality - or, in other words, the same volume - of
Coca-Cola.
2. The second stage is at the product group level, where the price relatives calculated
for the products in the group are averaged to obtain unweighted PPPs for the group.
Coca-cola is for example included in the product group “Softdrinks and
Concentrates”.

3. The third stage is at the aggregation levels, where the PPPs for the product groups
covered by the aggregation level are weighted and averaged to obtain weighted PPPs
for the aggregation level up to GDP (in our example, aggregated levels are Non-
alcoholic beverages, Food…). The weights used to aggregate the PPPs in the third
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 stage are the expenditures on the product groups as established in the national
accounts.
How to use PPPs?

Which country has the world's largest economy? It would be easy to answer the question if
all countries used the U.S. dollar. You would look up each country's economic output as
measured by GDP. The country that produced the most would be No.1.
But all countries don't use the U.S. dollar. For example, China produced 127 trillion yuan's
worth of goods and services in 2017. Using an exchange rate of 6.37 yuan per dollar,
that's $11.97 trillion. The United States produced $19.36 trillion. But most of that difference
is because the cost of living in China is much lower than in the United States. Since this
method depends on exchange rates, China's GDP will change when its exchange rate
changes.
So how do you compare their output? PPP recalculates a country's GDP as if it were being
priced in the United States. The CIA World Factbook calculates PPP to compare output
between countries. It estimated that China's 2017 GDP was $23.1 trillion. It's much more
than the U.S. GDP of $19.4 trillion. According to PPP, China has the world's largest economy.
You could also use PPP to find out where you could get a McDonald's Big Mac for less. In
2018, the U.S. Big Mac cost $5.28. In China, you can get the same thing for only $3.17. The
Economist's Big Mac Index reveals what a Big Mac costs in 48 countries.
The Big Mac is a good product to use to understand PPP:-
Like most other sandwiches, the Big Mac doesn't travel well in its final form so it's not
exported. Most of its price depends on local labor and restaurant rental costs. Since labor
in China is cheaper, the Big Mac costs less than in the United States. The Big Mac Index will
tell you a lot about a country's cost of living. If you want to live cheap, and you can move to
any country in the world, use the Big Mac Index.
Thanks to McDonald's standards, a Big Mac is basically the same sandwich anywhere in the
world. You aren't getting a smaller sandwich in China because it's almost $2 cheaper.
Purchasing power parity solves this problem. It recalculates the value of a country's goods
and services as if they were being sold at U.S. prices. Under PPP, a Chinese Big Mac costs
$5.04, the same as it does in the United States.
Although it doesn't happen often, PPP is also used to set the exchange rate for new
countries. It is also used to forecast future real exchange rates.
The major use of PPPs is as a first step in making inter-country comparisons in real terms of
gross domestic product (GDP) and its component expenditures. GDP is the aggregate used

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most frequently to represent the economic size of countries and, on a per capita basis, the
economic well-being of their residents. Calculating PPPs is the first step in the process of
converting the level of GDP and its major aggregates, expressed in national currencies, into
a common currency to enable these comparisons to be made.
Explaination of PPP:-
What are the products included in the basket of goods and services used for the
calculation of PPPs and how many are they?
The basket of goods and services priced for the PPP exercise is a sample of all goods and
services covered by GDP. The final product list covers around 3,000 consumer goods and
services, 30 occupations in government, 200 types of equipment goods and about 15
construction projects. The large number of products is to enable countries to identify goods
and services which are representative of their domestic expenditures.
How are annual PPP time series constructed?
Since December 2016, the OECD has improved the quality of its annual PPP time series by
(1) integrating survey results as soon as they become available without waiting for the
completion of the whole survey cycle every three years, (2) relying on price deflators at a
detailed level for annual extrapolations, and (3) increasing the frequency of some surveys
(national accounts’ expenditure weights, compensation of employees, housing rents).
When are PPPs updated and revised?
PPPs for a given year T are published in five steps:

 At T+2 months: first PPP estimates, for GDP only

 At T+6 months: second PPP estimates, based on detailed extrapolations, for GDP,
households’ Actual Individual Consumption (AIC) and Individual Household
Consumption (IHC)
 At T+12 months: third PPP estimates, incorporating all price and expenditure data for
year T
 At T+24 months: fourth PPP estimates, incorporating updated expenditure estimates
 At T+36 months: final PPP estimates for year T

In other words, the following results for GDP, AIC and IHC were published in December 2016:
 Final results for the year 2013
 Fourth estimates for the year 2014
 Third estimates for the year 2015

In February 2017, first estimates for the year 2016 were published, second estimates will be
published in June 2017.
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Please note that in December 2016, PPP data from 1995 to 2012 were exceptionally revised
for all European countries

What are the differences between PPP for GDP, PPP for private consumption and PPP for
actual individual consumption?
The PPP for GDP covers both final consumption expenditure (household and government)
and gross capital formation. The PPP for actual individual consumption covers all
households consumption expenditure and that part of government final expenditure which
covers services it supplies to individual households, for example housing, health, education,
social protection etc ... (in other words, it does not include government final expenditure on
those services it supplies to household collectively such as defence, police, environment
protection ...). The PPP for Household Final Consumption (or Private Consumption) covers
the expenditure by households on individual consumption of goods and services, including
those sold at prices that are not economically significant.
Two different yardsticks :-
International financial institutions produce a wide range of regional and global statistics.
The IMF, one of these institutions, publishes many of its statistics—such as the growth of
real gross domestic product (GDP), inflation, and current account balances—twice a year
in its World Economic Outlook (WEO). These statistics combine, or aggregate, the results
from many countries into an average. The importance, or weight, of an individual
country’s data in the overall result depends on the size of its economy relative to the
others being compared. To derive these weights, one converts the GDP of a country in
terms of its national currency into a common currency (in practice, the U.S. dollar).

One of the two main methods of conversion uses market exchange rates—the rate
prevailing in the foreign exchange market (using either the rate at the end of the period
or an average over the period).

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.

To understand PPP, let’s take a commonly used example, the price of a hamburger. If a
hamburger is selling in London for £2 and in New York for $4, this would imply a PPP
exchange rate of 1 pound to 2 U.S. dollars. This PPP exchange rate may well be different
from that prevailing in financial markets (so that the actual dollar cost of a hamburger in
London may be either more or less than the $4 it sells for in New York). This type of cross-
country comparison is the basis for the well-known “Big Mac” index, which is published

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by the Economist magazine and calculates PPP exchange rates based on the McDonald’s
sandwich that sells in nearly identical form in many countries around the world.

Of course, any meaningful comparison of prices across countries must consider a wide
range of goods and services. This is not an easy task, because of the amount of data that
must be collected and the complexities in the comparison process. To facilitate price
comparisons across countries, the International Comparisons Program (ICP) was
established by the United Nations and the University of Pennsylvania in 1968. PPPs
generated by the ICP are based on a global survey of prices. For the 2003–06 round, each
of the participating countries (about 147) provided national average prices for 1,000
closely specified products.

PPP versus market rates

So which method is better? The appropriate way to aggregate economic data across
countries depends on the issue being considered. Market exchange rates are the logical
choice when financial flows are involved. For example, the current account balance—
which measures the funds coming into and going out of a country—represents a flow of
financial resources across countries. It is appropriate to use the market exchange rate to
convert these flows into dollars when aggregating across regions or calculating the global
current account discrepancy. But for other variables, the decision is less clear cut. Take
real GDP growth. International organizations use different approaches. The World Bank
uses market-based rates to determine the weights in its regional and global aggregations
of real GDP, whereas the IMF and the Organization for Economic Cooperation and
Development use weights based on PPP rates (although the IMF also publishes a global
growth aggregate based on market rates in the WEO). Each methodology has its
advantages and disadvantages.

Advantages of PPP:

A main one is that PPP exchange rates are relatively stable over time. By contrast, market
rates are more volatile, and using them could produce quite large swings in aggregate
measures of growth even when growth rates in individual countries are stable. Another
drawback of market-based rates is that they are relevant only for internationally traded
goods. Nontraded goods and services tend to be cheaper in low-income than in high-
income countries. A haircut in New York is more expensive than in Lima; the price of a
taxi ride of the same distance is higher in Paris than in Tunis; and a ticket to a cricket game
costs more in London than in Lahore. Indeed, because wages tend to be lower in poorer
countries, and services are often relatively labor intensive, the price of a haircut in Lima
is likely to be cheaper than in New York even when the cost of making tradable goods,
such as machinery, is the same in both countries. Any analysis that fails to take into
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account these differences in the prices of nontraded goods across countries will
underestimate the purchasing power of consumers in emerging market and developing
countries and, consequently, their overall welfare. For this reason, PPP is generally
regarded as a better measure of overall well-being.

Drawbacks of PPP:
The biggest one is that PPP is harder to measure than market-based rates. The ICP is a
huge statistical undertaking, and new price comparisons are available only at infrequent
intervals. Methodological questions have also been raised about earlier surveys. Between
survey dates, the PPP rates must be estimated, which can introduce inaccuracies into the
measurement. Also, the ICP does not cover all countries, which means that data for
missing countries must be estimated.

Does it make a difference?

It depends. There is a large gap between market- and PPP-based rates in emerging market
and developing countries, for most of which the ratio of the market and PPP U.S. dollar
exchange rate is between 2 and 4. But for advanced economies, the market and PPP rates
tend to be much closer. As a result, developing countries get a much higher weight in
aggregations that use PPP exchange rates than they do using market exchange rates. The
weights of China and India in the world economy are far greater using PPP exchange rates
than market-based weights.

Thus, the choice of weights makes a big difference in calculations of global growth, but
little difference to estimates of aggregate growth in advanced economies. The per capita
income gap between the richest and poorest countries is modestly reduced under PPP
exchange rates (although it remains exceptionally large), and some countries jump up or
down the income scale depending on the exchange rate conversion used.

Why We Don't Live in a PPP World :-

PPP depends on the law of one price. That states that once the difference in exchange
rates is accounted for, then everything would cost the same.
That's not true in the real world for four reasons. First, there are differences
in transportation costs, taxes, and tariffs. These costs will raise prices in a country. Countries
with many trade agreements will have lower prices because they have fewer tariffs. Socialist
countries will have higher costs because they have more taxes.
A second reason is that some things, like real estate and haircuts, can't be shipped. Only
ultra-wealthy global travellers can compare the prices of homes in New York to those in
London.
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A third reason is that not everyone has the same access to international trade. For example,
someone in rural China can't compare the prices of oxen sold throughout the world. But
Amazon.com and other online retailers are providing more real purchasing power parity to
even rural dwellers.
A fourth reason is that import costs are subject to exchange rate fluctuations. For example,
when the U.S. dollar weakens, then Americans pay more for imports. The most significant
driver of changing exchange rate values is the foreign exchange market. It creates wide
swings in exchange rate values. For example, in 2014, many traders shorted the euro. The
European Union's currency dropped. As a result, costs throughout the EU also fell. When
traders began shorting the U.S. dollar in 2017, the dollar weakened.

The Bottom Line

The best way to understand PPP is to study the Big Mac Index. This index was created as a
humorous attempt to illustrate how the PPP worked by comparing the prices of a globally
sold product, the McDonald’s Big Mac burger. The Big Mac Index has been published in The
Economist since 1986.
Calculating for purchasing power parity allows economists to determine the cost of living in
other countries compared to the United States. PPP is a good tool for comparing GDP
outputs between nations. It is also used to determine which have large or small economies.
But since it involves many factors such as differences in taxes, tariffs, transportations costs,
import costs, and the like, the PPP calculation is highly complex. This is best done by experts.

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References :-

https://www.imf.org/external/pubs/ft/fandd/basics/ppp.htm

https://www.oecd.org/sdd/prices-ppp/purchasingpowerparities-
frequentlyaskedquestionsfaqs.htm

https://www.thebalance.com/purchasing-power-parity-3305953

**** Thank You ****

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