- Purchasing power parity (PPP) is a fundamental economic metric that allows for comparison of the real standard of living between different countries, eliminating distortions from market exchange rates to measure how much can actually be bought with money in each place.
- To calculate PPP, the price of a standard basket of goods and services in a country's local currency is divided by the price of that same basket in another country's currency, thus obtaining a theoretical exchange rate that would equalize purchasing power in both nations.
- Although it offers a more stable and equitable view of the global economy, purchasing power parity has advantages and limitations; on the one hand, it better reflects well-being in emerging economies, but on the other, it can be inaccurate by not considering transportation costs, tariffs, or quality differences in non-exportable services.
What is purchasing power parity (PPP)?
Purchasing Power Parity (PPP), known in English as Purchasing Power Parity (PPP)It is an economic theory and a measurement technique used to adjust the economic figures of different countries. Its main objective is to allow a realistic comparison between the currencies of different nations, based on what can actually be bought with them.
Instead of simply using the foreign exchange market rate (which can be highly volatile due to speculation), PPP seeks to determine how much a standard basket of goods and services costs in one country compared to another.
What does purchasing power parity mean?
Essentially, PPP means that money should have the same purchasing power anywhere in the world once adjusted for the exchange rate.
If the theory were perfectly fulfilled (absolute PPP), with the same amount of money converted to the local currency, you should be able to buy exactly the same products in New York, Madrid or Buenos Aires.
When this does not happen, a currency is said to be overvalued (more expensive than it should be) or undervalued (cheaper than it should be) in relation to the other.
What is PPA used for?
PPP is a fundamental tool for both economists and international organizations (such as the IMF or the World Bank) for several reasons:
- Comparison of living standards: Allows for a fairer comparison of GDP between different countries, reflecting the real well-being of their inhabitants.
- Exchange rate analysis: Helps predict whether a currency will depreciate or appreciate in the long term.
- Business decision-making: Multinationals use it to set prices and wages in different markets.
- Inflation adjustments: Helps to understand how the differential inflation between two countries affects their competitiveness.
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Types of purchasing power parity
There are two main ways to understand and apply this theory:
Absolute parity
It is based on the "Law of One Price." This law states that an identical product should have the same price in two different countries when expressed in a common currency. If the price differs, arbitrage (buying low in one place and selling high in another) should, in theory, equalize prices.
Relative parity
It's a more dynamic and realistic version. It doesn't assume identical prices, but rather that changes in the exchange rate between two currencies over time should equal the difference in the two countries' inflation rates. In other words, if one country has higher inflation than another, its currency should depreciate to compensate for that loss of purchasing power.
How to calculate purchasing power parity
The calculation is based on the relationship between the price levels of two economies.
Description of the formula for calculating PPP
The basic formula for obtaining the exchange rate according to PPP is:
S = P1 / P2
Where:
- S: PPP (implicit) exchange rate.
- P1: Price of the basket of goods in Currency 1 (Country A).
- Price of the basket of goods in Currency 2 (Country B).
Step-by-step example of how to calculate purchasing power parity
Let's imagine we want to compare the purchasing power between the United States (USD) and Mexico (MXN) using a pair of identical sneakers.
- Price in the USA: $100 USD.
- Price in Mexico: $2.200 MXN.
- Calculation: We divide the price in pesos by the price in dollars.
$2.200 / 100 = $22
- Result: The PPP exchange rate is 22 MXN per 1 USD.
- Interpretation: If the actual market exchange rate is 18 MXN per 1 USD, it means the Mexican peso is stronger (or the dollar is cheaper) in the market than PPP suggests. For an American, Mexico would be "expensive" to buy those sneakers in compared to the theoretical exchange rate.
How to use PPA in real life
Beyond economic theory, PPP has practical uses for ordinary people:
- Tourism and travel: This helps you determine if a destination is cheap or expensive. If you travel to a country with a high GDP PPP but low prices compared to your currency, your money will go further.
- Remote work and expats: When negotiating a salary abroad, you shouldn't just look at the currency conversion, but also the cost of living (PPP). Earning €3.000 in Switzerland is not the same as earning €3.000 in Portugal; in terms of PPP, the salary in Portugal offers a higher quality of life.
Advantages of using purchasing power parity
- Stability: PPP exchange rates are more stable than market exchange rates, which fluctuate daily.
- Realism: It offers a more accurate picture of the size of emerging economies, where service prices are usually much lower.
- Comparability: Facilitates the comparison of poverty and wealth data at a global level.
Limitations of purchasing power parity
Despite its usefulness, PPA is not perfect:
- Transportation costs and tariffs: Theory assumes free trade, but in reality there are shipping costs and taxes that distort prices.
- Non-tradable goods: Services such as a haircut or rent cannot be exported, so their prices vary greatly and distort the comparison.
- Quality differences: A product may have the same name in two countries, but different quality, which invalidates a direct price comparison.
How does PPP relate to GDP?
This is perhaps the most famous application. There are two ways to measure Gross Domestic Product:
- Nominal GDP: Uses market exchange rates. It tends to favor countries with strong currencies (such as the US or the Eurozone).
- GDP PPP: Adjusts GDP according to the local cost of living. Under this metric, economies like China or India significantly increase their weight in the world ranking, since, although their currencies are weaker, the domestic cost of living is low, allowing for greater real production and consumption.
PPP in macroeconomics and international trade
In macroeconomics, purchasing power parity (PPP) acts as a long-term anchor. Economists assume that, over time, market exchange rates will tend to move toward the PPP rate. If there is a large divergence, a market correction or inflationary adjustments can be expected. It is vital for understanding trade flows: a country with very low domestic prices (an undervalued currency according to PPP) will tend to export more because its products are competitive abroad.
PPP Indices
To make this concept digestible, simplified indices have been created.
Big Mac Index
Created by The Economist in 1986, it is the most famous example of PPP. It uses McDonald's Big Mac as the "basket of goods," since it is produced almost identically worldwide.
If a Big Mac costs $5.00 in the US and the equivalent of $2.50 in another country (at the current exchange rate), the index suggests that the currency of that second country is undervalued by 50%. It's a fun but surprisingly accurate way to see if currencies are at their "correct" level.
Conclusion
Purchasing Power Parity (PPP) is much more than a mathematical formula; it's an essential lens for seeing the global economy clearly. It reminds us that the value of money isn't in the number printed on the bill, but in what that bill can buy. Whether you're comparing the economic power of nations or planning your next vacation, understanding PPP allows you to make more informed financial decisions and grasp the global economic reality beyond the headlines of the foreign exchange market.
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