What Is Purchasing Power Parity (PPP)?

Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time. One popular metric is purchasing power parity (PPP).

Purchasing power parity (PPP) is an economic theory that compares different countries' currencies through a "basket of goods" approach. According to this concept, two currencies are in equilibrium or at par when a basket of goods (taking into account the exchange rate) is priced the same in both countries. Closely related to PPP is the law of one price (LOOP), which is an economic theory that predicts that after accounting for differences in interest rates and exchange rates, the cost of something in country X should be the same as that in country Y in real terms.

The relative version of PPP is calculated with the following formula:

Where:

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

To make a comparison of prices across countries that holds any type of meaning, a wide range of goods and services must be considered. The amount of data that must be collected and the complexity of drawing comparisons makes this process difficult. To facilitate this, the International Comparison Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations. Purchasing power parities generated by the ICP are based on a worldwide price survey comparing the prices of hundreds of various goods. This data, in turn, helps international macroeconomists come up with estimates of global productivity and growth. 

Every three years, the World Bank constructs and releases a report comparing 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. These actions often impact financial markets in the short run.

Some forex traders also use PPP to find potentially overvalued or undervalued currencies. 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.

Using PPPs is the alternative to using market exchange rates. The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. Purchasing power is determined in each country based on its relative cost of living and inflation rates. Purchasing power plus parity equalizes the purchasing power of two differing currencies by accounting for differences in inflation rates and cost of living.

As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's Corp.’s (MCD) Big Mac burger in many countries since 1986. The highly publicized Big Mac index measures the purchasing power parity (PPP) between nations using the price of a Big Mac as the benchmark. The Big Mac index suggests, in theory, changes in exchange rates between currencies should affect the price consumers pay for a Big Mac in a particular nation, replacing the "basket" with the famous hamburger. This is a prime example of how the "law" of one price fails in practice.

For example, if the price of a Big Mac is $4.00 in the U.S. and 2.5 pounds sterling in Britain, we would expect the exchange rate to be 1.60 (4/2.5 = 1.60). If the exchange rate of dollars to pounds is any greater, the Big Mac index would state the pound was overvalued, any lower and it would be undervalued.

That said, the index has its flaws. First, the Big Mac's price is decided by McDonald's Corp., which can significantly affect the Big Mac index. Also, the Big Mac differs across the world in size, ingredients and availability. That being said, the index is meant to be light-hearted and is a great example used by many schools and universities to teach students about 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 takes the nominal GDP and adjusts it for inflation. 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.

One way to think of what GDP with PPP represents is to imagine the total collective purchasing power of Japan if it were used to make the same purchases in U.S. markets. This only works after all yen are exchanged for dollars. Otherwise, the comparison does not make sense.

The following example illustrates this point. Suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy the same shirt in Germany. To make an apples-to-apples comparison, the €8.00 in Germany needs to be converted into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would be 15/10, or 1.5. For every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany.

The five nations with the highest GDP in market exchange terms are the U.S., China, India, Japan and Germany. This comparison changes when PPP is used. According to 2017 data from the International Monetary Fund (IMF), China has overtaken the U.S. as the world's largest economy based on purchasing power 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.

Empirical evidence has shown that for many goods and baskets of goods, PPP is not observed in the short-term, and there is uncertainty over whether it applies in the long-term. In “Burgernomics,” (2003) a prominent paper that explores the Big Mac Index and PPP, authors Michael R. Pakko and Patricia S. Pollard cite several factors as to why PPP theory does not line up with reality:

• Transport costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will consequently sell at a relatively higher price than the same goods available from local sources.
• Taxes: When government sales taxes, such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country.
• Government intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing the price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower. Governments that restrict exports will see a good's price rise in importing countries facing a shortage and fall in exporting countries where its supply is increasing.
• Non-traded services: The Big Mac's price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the storefront, insurance, utility expense and the cost of labor.

While not perfect, purchase power parity does allow one to compare pricing between countries with differing currencies. Just don't try to buy a hamburger in Luxembourg if you plan on exchanging for Russian rubles!