Macroeconomic analysis heavily relies on several different metrics to compare economic productivity and standards of living between countries. One popular metric is purchasing power parity (PPP), an economic theory that compares different countries' currencies through a "basket of goods" approach. According to this concept, two currencies are in equilibrium (at par) when a basket of goods is priced the same in both countries, taking into account the exchange rates.
- Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts to compare economic productivity and standards of living between countries.
- Some countries adjust their gross domestic product (GDP) figures, to reflect PPP.
How to Calculate Purchasing Power Parity
The relative version of PPP is calculated with the following formula:
S represents the exchange rate of currency 1 to currency 2
P1 represents the cost of good X in currency 1
P2 represents the cost of good X in currency 2
How PPP Is Used
To make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. But this 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. So to facilitate this with greater ease, in 1968, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP). PPPs generated by the ICP, based on a worldwide price survey comparing the prices of hundreds of various goods, help international macroeconomists estimate global productivity and growth.
Every three years, the World Bank releases a report that compares 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, which can have an immediate short-term impact on financial markets. Some forex traders use PPP to find potentially overvalued or undervalued currencies. And investors who hold stock or bonds of foreign companies may survey PPP figures to predict the impact of exchange-rate fluctuations on a country's economy.
GDP and PPP
In 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 GDP for inflation. But even further: some accounts of GDP are adjusted for PPP. 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 PPP works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy the 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.
Which Nations Have the Highest Purchasing Power?
The five nations with the highest GDP in market exchange terms are as follows:
- United States
But this comparison changes when PPP is introduced. According to 2017 data from the International Monetary Fund (IMF), based on purchasing power, China boasts the world's largest economy, with 23,122 billion current international dollars. The U.S. comes in second with 19,362 billion. India, Japan and Germany follow with 9,447 billion, 5,405 billion, and 4,150 billion, respectively.
The Downfalls of PPP: Short-Term vs. Long-Term Parity
Since 1986, The Economist Magazine has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac burger, across many countries, resulting 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 PPP theory does not line up with reality:
- Transport costs: Goods unavailable locally must be imported, resulting in transport costs. Imported goods will consequently sell at relatively higher prices than identical locally-sourced goods.
- Taxes: Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.
- Government intervention: Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.
- Non-traded services: The Big Mac's price factors input costs that are not traded, such as insurance, utility, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.
- Market competition: Goods might be deliberately priced higher in a country, because a company there may have a competitive advantage over other sellers, either because it has a monopoly, or because it is part of a cartel of companies that manipulate prices.
The Bottom Line
While it's not a perfect measurement metric, purchase power parity does let one compare pricing between countries with differing currencies. Just don't try to buy a hamburger in Luxembourg if you plan on exchanging your money for Russian rubles!