Purchasing Power Parity

Purchasing Power Parity (PPP) is an equivalence coefficient between currencies calculated based on different price levels in various countries, allowing us to economically evaluate the Gross Domestic Product (Gross Domestic Product) of each country. GDP ) for reasonable comparison. The purchasing power parity calculation unit is the international dollar (Intl.$) or "international currency unit" (ICU). Purchasing power parity is based on the US dollar, that is, the purchasing power of 1 US dollar in the United States is the reference base; therefore, the purchasing power of 1 international dollar in individual countries is equal to the purchasing power of 1 US dollar in the United States. Therefore, in many cases, purchasing power parity is directly calculated using US$.

Why use purchasing power parity?

The purpose of purchasing power parity is to make a reasonable comparison of the GDP of various countries, because GDP is an important indicator of a country's economic size and development level.

However, if we directly use the market exchange rate to convert the GDP of each country into the same currency, such as the US dollar, we will ignore the differences in price levels between countries and be misleading. For example, if the Mexican peso loses half its value relative to the U.S. dollar, Mexico's GDP in U.S. dollars will also be halved.

However, this does not mean that Mexicans have become poorer. If income and price levels in peso remain unchanged, and import and export goods are not important to Mexicans' living standards, then currency depreciation will not bring about a deterioration in Mexicans' quality of life. This problem can be avoided if purchasing power parity is used, because it takes into account the price differences between countries for the same basket of goods and services, thus reflecting the actual spending power and living standards of people in each country.

How to calculate purchasing power parity?

Calculating purchasing power parity requires knowing two data: market exchange rates and price indexes. Market exchange rate refers to the ratio of one currency to another, usually determined by market supply and demand. The price index refers to the relative change in the overall price level of a certain quantity and quality of goods and services in a country or region during a certain period compared with the base period. It is usually released regularly by the statistical department. With these two data, purchasing power parity can be calculated using the following formula:

$$PPP= rac{market exchange rate imes base country price index}{comparison country price index}$$

Among them, the United States is usually chosen as the base country because the U.S. dollar is the most widely used and accepted international reserve currency. A comparator country is any other country with which one wants to compare GDP or living standards with the benchmark country. For example, if you want to compare the GDP and living standards of China and the United States in 2020, you can use the following data to calculate:

Market exchange rate: 1 US dollar = 6.8974 RMB

US Price Index: 258.811

China Price Index: 102.5

Substituting into the formula we get:

$$PPP= rac{6.8974 imes 258.811}{102.5}=17.35$$

This means that in 2020, 1 US dollar in China can purchase goods and services equivalent to 17.35 RMB in the United States. In other words, in 2020, the Chinese yuan has a great purchasing power advantage over the US dollar.

What are the advantages and disadvantages of purchasing power parity?

Purchasing power parity, as a method for comparing the economic levels of different countries, has the following advantages and disadvantages:

Advantage

Purchasing power parity can more truly reflect the actual consumption power and living standards of people in various countries, and is not affected by market exchange rate fluctuations and policy intervention.

Purchasing power parity can more fairly compare the GDP gap between developing and developed countries, because developing countries usually have low costs of labor, raw materials, and daily necessities.

Purchasing power parity enables a more effective analysis of the structure and dynamics of the global economy because it takes into account the demand and supply of different types of goods and services across countries.

Shortcoming

Purchasing power parity is difficult to accurately measure the price differences between countries for the same basket of goods and services, because each country has its own unique consumption structure, preferences, brands, quality, taxes and other factors.

Purchasing power parity ignores differences in the tradability and substitutability of goods and services between countries, because some goods and services cannot be traded across borders or there are barriers such as high transportation costs, tariffs, and quotas.