close
Business
close
Macro Moves

Understanding Purchasing Power Parity

Created on 14 Dec 2022

Wraps up in 12 Min

Read by 1.9k people

The term "purchasing power parity," or PPP, refers to the relative purchasing power of different national currencies around the world.

To put it another way, the idea behind purchasing power parity is that all countries' exchange rates should be equal so that consumers can pay the same price for the same amount of goods and services everywhere in the world.

For instance, if the conversion rate is taken into account as being $1 for every ₹80, a smartphone that costs roughly ₹15,000 in India would cost about $187.5 in the USA.
Now we know why flaming hot Cheetos are ₹500!

What is Purchasing Power Parity?

The number of units of a country's currency needed to purchase the same quantity of goods and services on the local market as one dollar would in the US is known as purchasing power parity.

Using the method of "purchasing power parity," one can calculate the exchange rate between two currencies that will accurately reflect their relative purchasing power in the respective countries.

A technique for making multilateral comparisons between the national incomes and living standards of various nations is the idea of purchasing power parity (PPP). The cost of a predetermined basket of goods and services is a gauge of one's purchasing power. In light of the pricing levels in both nations, parity between two countries means that a unit of currency in one country will buy the same assortment of products and services in the other.

Globally, purchasing power parity is used to compare income levels across nations. Thus, PPP makes it simple to comprehend and analyse the data of any nation.

Purchasing Power Parity Theory

The theory seeks to ascertain the changes that two currencies' exchange rates should undergo in order to bring their buying power to parity. In other words, after taking into account exchange rates, the cost of a comparable good must be the same in both currencies. Each currency's purchasing power is calculated during the procedure.

A PPP ratio, which indicates the total number of baskets of goods and services that a single unit of a country's currency can purchase, evaluates how far from the condition of parity the two countries’ currencies are. 

How come I’m poor in both countries?

For instance, it is obvious that the purchasing power of £1 in Britain is equal to the purchasing power of ₹101 in India. This means if a particular variety of items can be purchased for £1 in Britain, a similar assortment can be bought for ₹101 in India. According to the notion of purchasing power parity, the exchange rate will be £1 = ₹101.

We have high hopes, Rishi Sunak!

Let's use another illustration. Let's say one dollar can buy a certain assortment of goods in the USA. The identical assortment of goods costs ₹80 in India. The exchange rate will thereafter typically be $1 = ₹80.

Imagine that the pricing levels in the two nations stay the same but that the exchange rate changes to $1=₹81 for some reason. This indicates that the rupee may buy more goods than the dollar. At this exchange rate ($1 = ₹ 81), it will be profitable for people to buy the specified collection of goods in India for ₹80, sell them in the United States for another dollar, and make a profit of one rupee for every dollar's worth of transactions.

Due to the small number of persons who will export goods from India to the USA, there will be a high demand for rupees in the USA but a low supply. This will continue till it reaches $1 = ₹80, and the value of the rupee will increase in relation to the dollar. Then, Indian imports won't provide unusual gains. The purchasing power parity between the two nations is defined as $1 = ₹80.

Therefore, while the market forces of supply and demand determine the value of a unit of one currency relative to another currency at any one moment, over the long term, the exchange rate is decided by the relative values of the two currencies as represented by their respective purchasing power.

To put it another way, the exchange rate often rests at the value that indicates parity between the relative purchase capacities of the two currencies. The purchasing power parity is the level at which we are. As a result, in a system of independent paper standards, it is claimed that a currency's external worth ultimately depends on how much it can buy domestically in comparison to other currencies. In other words, under such a system, exchange rates often depend on the relative purchasing power parities of various currencies in various nations.
In the aforementioned scenario, the value of the rupee will precisely decrease by half if prices in India double while prices in the US remain unchanged. $1 will now be worth ₹160. This is due to the fact that in India, ₹160 will now buy the same assortment of goods that ₹80 previously did. We assume that prices in the USA stay the same. However, the parity won't change if prices doubled in both nations. In reality, however, the cost of shipping products (including tariffs, etc.) from one nation to another will change the parity.

Purchasing Power Parity Formula

One of the most crucial macroeconomic indicators used by economists to assess a nation's economic output and standard of living is the purchasing power parity.

The law of one pricing, which asserts that identical commodities will have the same price, is the foundation of PPP.

The following is an expression for the purchasing power parity formula:

S = P1/P2

Where:
S is the currency 1 to currency 2 exchange rate.
P1 is the price of a good in currency 1
P2 is the price of the same good in currency 2.

Examples of PPP

For instance, a loaf of bread costs $2 in the US, which is equal to ₹160 in India. In contrast, a loaf of bread in India costs roughly ₹10, or about 12 cents. As a result, there is an opportunity for arbitrage where individuals in India can store up bread and export it to the US, where they can sell it for a healthy profit.
According to the idea of purchasing power parity, since the two countries are trading the same items, their purchasing power should be equivalent. This means that the price-to-exchange rate ratio should be one, not that the exchange rate should be equal to one. According to this illustration, the exchange rate should be $2 = ₹10 and $1 = ₹5. As a result, the value of the rupee is low.

GDP (PPP): Meaning

Gross domestic product, calculated using purchasing power parity, is known as GDP (PPP). The order of the countries is based on anticipated GDP (PPP) estimates from financial and statistical organisations that compute using market or official government exchange rates. PPP takes into account the relative cost of local goods, services, and inflation rates rather than international market exchange rates, which could distort the real differences in per capita income, making GDP comparisons using PPP more useful than those using nominal GDP when evaluating a state's domestic market. However, it has limitations for comparing the quality of similar items between nations and when estimating financial flows between them.

These surveys, like the International Comparison Program, include both tradable and non-tradable goods in an effort to evaluate a representative basket of all interests. PPP is frequently used to measure global poverty thresholds and is used by the United Nations to construct the human development index.

Gross domestic product is converted to international dollars using purchasing power parity rates and divided by the entire population to calculate GDP per capita (PPP based). The purchasing power of a global dollar is equivalent to that of an American dollar in the United States over GDP. The ratio of how many units of country A's currency is required to buy the same amount of a particular commodity or service in country A with how much of a product one unit of country B's currency will buy in country B is known as the purchasing power parity (PPP) between nations A and B. PPPs can be stated using either nation's currency.

They are typically represented in terms of a single currency and calculated across a large number of nations, with the US$ being the most widely used base currency or "numeraire" in practice.

Purchasing Power Parity by Country

Comparing a country's purchasing power to that of other countries in a specific year is called Purchasing Power Parity (PPP) by the government. The Gross Domestic Product, or GDP, measures the worth of a nation's commodities and services. The exchange rates and how the resulting value relates to the items and services produced in that nation impact a country's PPP.

To compare one country to another, the PPP uses the GDP amount and the current exchange rates. These number is derived by summing together the total consumption of goods and services by all domestic households, the federal government, total net exports, and fixed capital formation.

So, for instance, the PPP between the United States and India is computed by determining the exact GDP of both nations and then determining an equivalent dollar value in USD, or United States Dollar. LCU refers to Local Currency Unit.

1. China
China, despite being a developing country, is thought to have the greatest PPP in the entire world. This is due to the country's economy being the largest in the world, despite the fact that the bulk of its population earns extremely low wages.

China may currently have the largest PPP in the world, but it is not by much, and it is frequently trailed by or precedes the United States by a small margin.

For instance, in 2017, China's PPP was $19.6 trillion USD, while the US's PPP was $19.5 trillion USD.

2. USA
The world's second-largest economy after China in terms of GDP is unquestionably the United States. With a GDP of $25.35 trillion and a PPP that handled more than 16% of the world's products and services in 2022, the United States was the world's largest economy.

This was in spite of the fact that the US economy experienced a substantial slowdown after the COVID-19 epidemic, which caused a significant global economic shutdown.

3. UK
United Kingdom's purchasing power parity in 2021 was 0.7 LCU (Local Currency Unit) per foreign currency. Despite significant fluctuations in recent years, the United Kingdom's purchasing power parity generally declined from 2002 to 2021, reaching 0.7 LCU per international currency in that year.

4. Spain
Spain's purchasing power parity in 2021 was 0.6 LCU (Local Currency Unit) per foreign currency. Spain's purchasing power parity decreased gradually over time, from 0.7 LCU per USD in 2002 to 0.6 LCU per USD in 2021.

5. Australia
Australia's purchasing power parity in 2021 was 1.4 LCU per foreign currency. Despite significant fluctuations in recent years, Australia's purchasing power parity generally increased from 2002 to 2021, reaching 1.4 LCU for every foreign dollar in that year.

6. France
France's purchasing power parity in 2021 was 0.7 LCU per foreign currency. From 0.9 LCU per international currency in 2002 to 0.7 LCU per international currency in 2021, France's purchasing power parity decreased gradually.

7.  Brazil
Brazil's purchasing power parity has risen steadily between 2008 and 2021. The PPP was roughly 1.22 NCU (National Currency Unit) per USD in 2008, but it increased to 2.53 NCU by 2021. Brazil's capital city, Brasilia, had the second-highest local purchasing power in Latin America and the Caribbean in the latter year.
According to the concept of purchasing power parity, more national currency units are required to purchase the same amount of goods and services abroad than they are in the United States. By eliminating pricing discrepancies, this conversion strives to equalise the purchasing power between nations.

8. Mexico
Mexico's purchasing power parity in 2021 was 10 LCU (Local Currency Unit) for every USD. The purchasing power parity of Mexico increased significantly over the past 20 years, growing from 6.6 to 10 LCU per international currency at an increasing yearly rate that peaked at 5.54% in 2017 and then fell to 3.51% in 2021.

9. Canada
Canada's purchasing power parity in 2021 was 1.3 LCU per foreign currency. Despite significant recent fluctuations, Canada's purchasing power parity generally increased from 2002 to 2021, reaching 1.3 LCU for every international currency in that year.

10. Russia
Russian Federation's purchasing power parity in 2021 was 27.3 LCU per foreign currency. From 9.3 LCU per international currency in 2002 to 27.3 LCU per international currency in 2021, the Russian Federation's purchasing power parity increased at an average yearly rate of 6.03%.

11. South Africa
South Africa's purchasing power parity in 2021 was 7.2 LCU per foreign currency. With an average yearly growth rate of 4.31%, South Africa's purchasing power parity climbed from 3.2 LCU per international $ in 2002 to 7.2 LCU per international $ in 2021.

12. Indonesia
Indonesia's purchasing power parity in 2021 was 4,758.7 LCU per foreign currency. Indonesia's purchasing power parity climbed from 1,616.1 LCU to 1 USD in 2002 to 4,758.7 LCU to 1 USD in 2021, expanding at an average yearly rate of 5.94%.

13. Pakistan
Pakistan's purchasing power parity for international currencies in 2021 was 41.9 LCU. From 11.8 LCU per international currency in 2002 to 41.9 LCU per international currency in 2021, Pakistan's purchasing power parity increased at an average yearly rate of 7.01%.

14. Sri Lanka’s PPP
Sri Lanka's purchasing power parity in 2021 was 53.7 LCU for every US$. Sri Lanka's purchasing power parity increased from 20.9 LCU to 1 USD in 2002 to 53.7 LCU to 1 USD in 2021, expanding at an average yearly rate of 5.14%.

GDP per capita, PPP, 2021 - Country Rankings

The average for 2021 based on 173 nations was 21226.17 U.S. dollars. The country with the greatest value was Luxembourg, with 118680.05 U.S. dollars, while the country with the lowest value was Burundi, with 722.05 U.S. dollars. Available years for the indicator are 1990 through 2021. The chart for all the nations where data are available is shown below.

The chart for all the nations where data are available is shown below.

Countries 

GDP per capita, PPP, 2021

Available data 

Luxembourg

118680.05

1990 - 2021

Singapore

106032.23

1990 - 2021

Ireland

102154.44

1990 - 2021

Qatar

85128.23

2000 - 2021

Bermuda

77546.61

1990 - 2021

Switzerland

70792.66

1990 - 2021

Macao

67178.74

1990 - 2021

Norway

65688.55

1990 - 2021

USA

63069.23

1990 - 2021

Brunei

60640.97

1990 - 2021

 

Purchasing Power Parity of India

With a share of 7% of the global GDP, India currently has the third-largest economy in the world by purchasing power parity (PPP) terms after China (18%) and the US (16%). By 2027, it is anticipated that India's GDP, at current market exchange rates, will be $5 trillion. In terms of purchasing power parity, India's GDP will surpass $16 trillion by that year (up from $10 trillion in 2021).

Organisation for Economic Co-operation and Development (OECD), is headquartered in Paris France, and is a global association of 38 nations dedicated to democracy and the market economy.

According to OECD projections for 2021, the Indian GDP will surpass that of the United States by 2048. India's economy would surpass China's to become the second-largest in the world.

In terms of PPP, a country's prosperity and increase in productivity are correlated with an increase in the exchange rate. The Indian ₹ is expected to overtake the Indonesian Rupiah as the second-strongest currency in the world, surpassing it.

In 2017, India maintained and strengthened its position as the third-largest economy in the world, contributing 6.7% ($8,051 billion out of a total global GDP of $119,547 billion) in terms of PPPs, behind behind China (16.4%) and the United States (16.3%). In terms of its PPP-based contribution to both global gross capital formation and actual individual consumption, India is the third-largest economy in the world.

The Bottom Line

Gustav Cassel, a Swedish economist, introduced the idea of PPP in 1918 when he discussed the "law of one price." He attempted to demonstrate through this idea that equivalent commodities and services will be priced similarly in all marketplaces if they are stated in the same currency. PPP is a concept that economists use to compare and contrast the economic outputs of various nations. In order to assess a country's economic health, it is also utilised in conjunction with GDP measurements. PPP supports investors and dealers who work with foreign currencies. It can be used to determine a currency's strength or weakness.

PPPs can be used to indicate how an exchange rate might fluctuate as the economy grows. It can be difficult to evaluate the relative outputs and living standards of various economies because of the wide variations in inflation rates between nations. PPP ratios come into play when comparing economies and are frequently favoured by policymakers and scholars. Macroeconomic experts frequently use the purchasing power parity (PPP) statistic to compare the currencies of various nations using a "basket of goods" method.

Purchase power parity does allow for the potential of price comparison between nations with various currencies, even though it is not a precise measurement metric.

Call your NRI cousin for an iPhone; they have it cheaper than you.

comment on this article
share this article
Photo of Deb P Samaddar

An Article By -

Deb P Samaddar

263 Posts

12.4m Views

345 Post Likes

If people could be named after idioms, Deb would be called "I'm all ears." His brain is a storehouse, ever overflowing with derelict information. So, while most things he talks about are as useless as occasion-less greeting cards, everything he writes has the potential of bagging you multiple diplomas!

Topics under this Article

Share your thoughts

We showed you ours, now you show us yours (opinions 😉)

no comments on this article yet

Why not start a conversation?

Looks like nobody has said anything yet. Would you take this as an opportunity to start a discussion or a chat fight may be.

Under Macro Moves

"A few" articles ain't enough! Explore more under this category.

close
Share this post
share on facebook

Facebook

share on twitter

Twitter

share on whatsapp

Whatsapp

share on linkedin

Linkedin

Or copy the link to this post -

https://insider.finology.in/finance/purchasing-power-parity

copy url to this post
Copied