What is purchasing power parity?

Purchasing power parity, or PPP, is a theoretical way to measure and compare economic variables between different countries through the so called “basket of goods”. The concept of PPP represents a theoretical rate that allows you to buy the same amount of services and goods in every country.

Purchasing power parity is a popular macroeconomic metric used to compare the standards of living and productivity between countries. PPP enables analysts to calculate what the exchange rate between 2 currencies should be to make the purchasing power of both currencies equal.

Where have you heard about purchasing power parity?

The idea of PPP originated in 16th century with the School of Salamanca. Later in 1916, purchasing power parity developed its modern meaning through Swedish economist Gustav Cassel in “The Present Situation of the Foreign Trade”.

Before World War I, most countries applied the gold standard. The country’s exchange rate was synonymous with how much gold the currency was actually worth. The costs of war made them abandon the gold standard and print the money they needed, creating inflation. Gustav Cassel proposed to multiply the pre-war value of each currency by its inflation rate to obtain new parity. This worked as the basis of the modern PPP rate.

What you need to know about purchasing power parity.

The calculation of purchasing power parity may give you an idea of how much something would cost if different countries used the USD. The World Bank calculates purchasing power parity for every country in the world. It gives them a map, displaying the PPP ratio compared to the USA.

Purchasing power parity helps to determine which country has the world’s largest economy by recalculating countries’ GDPs as if they were priced in US dollars. According to the CIA factbook, which calculates PPP between countries, China has the largest GDP, followed by the European Union and the USA.

A McDonald’s Big Mac burger can serve as a good purchasing power parity example. The Economist’s Big Mac index, invented in 1986, shows how much a Big Mac costs in 48 countries. This index may tell you much about the cost of living in a particular country.

The purchasing power parity formula sounds like:

S= P1 / P2

Where:

• S = Exchange rate of currency 1 to currency 2
• P1 = Cost of good N in currency 1
• P2  = Cost of good N in currency 2

Purchasing power parity suggests that prices for services and goods in different countries should become equal over time. Today, people have an opportunity to shop around the globe, searching for the best prices.