# What is purchasing power parity?

Measuring economic activity within a country is difficult, because the ‘economy’ is a complex system with so many actors working together. A common way to deal with this is to focus on aggregating indicators such as gross national product: “the monetary value of all goods and services produced in a country country (or region) for a specific period of time”. This is what economists call Gross Domestic Product (GDP).

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GDP is a scale that uses prevailing national prices to estimate the value of production. In other words, GDP is calculated using the local currency. This means that in order to make meaningful comparisons across countries, it is necessary to convert these numbers into a common currency – using an appropriate ‘unit of measure’, for example. .

One option is to simply convert all country numbers into a common currency (e.g. US dollars) using exchange rates from the financial markets. But because market rates do not always reflect the extent of price differences between countries, economists often opt for an alternative. They created a ‘hypothetical currency’, called the ‘international dollar’, and used it as a common unit of measure. The idea is as follows: for the same amount of international dollars must buy roughly the same quantity and quality of goods and services in any country.

The conversion rates used to convert monetary values ​​in the local currency into ‘international dollars’ are known as ‘purchasing power parity rates’ (also referred to as conversion factors). PPP / Purchasing Power Parity ). Below we discuss where PPP rates come from, and why they can often be more useful than market exchange rates for comparison.

## What is purchasing power and why is it important?

Why do so many British retirees decide to move to Southern Spain? It’s not just the weather. It’s also because prices are lower in Spain than in the UK. You can buy more things with sterling while in Spain than you can in the UK. In other words, purchasing ability of the British Pound is higher in Spain than in Great Britain. The difference in price is the conversion rate PPP tries to capture.

If we are concerned with standards of living, any monetary income must be considered in relation to the quantity of goods and services it can buy in the country. local. The same type of meal in the same type of restaurant will cost different depending on the country it’s sold in. This is important for macroeconomic comparisons, and it is important for travelers as well: travel guides attempt to provide travelers with cross-country examples of differences in the cost of living. works, and for a very specific product, it’s also what the Big Mac index captures.

The graphic below shows the cross-country difference in purchasing power, which includes the United States as a reference country. Specifically, the numbers below correspond to the ratio of the price levels of the PPP conversion factors to the market exchange rate. Thus, numbers below 1 imply that if you exchange 1 dollar at a corresponding exchange market, the amount of money in the local currency will help you buy more things in that country than you can. can be purchased for \$1 in the United States in the same year.

A price of 0.5 represents a country in this map which means that for a given amount of US dollars you can buy twice as many products and services in that country as you would in the US . In countries with prices above 1, you can only buy fewer products and services than you can in the United States for the same amount of US dollars.

As we can see, the degree of price difference between developed and developing countries is much larger than between Spain and Great Britain. The amount of products and services you can buy with \$500 in the United States is very different from what you can buy for the same amount in rural India.

2016: Australia 1.07 / China 0.52 / Russia 0.38 / Vietnam 0.34 / Thailand 0.35/ Spain 0.73/ Germany 0.86 / India 0.26 / Me – Mexico 0.46 / Brazil 0.57 / United States 1

This is more important than GDP. The difference in price levels implies that for the same income in US dollars, you can be on the poverty line in the United States, but quite rich in rural India. For this reason, we need to consider purchasing power when comparing variables such as poverty rates across countries.

From the above explanation, it is clear that we need to adjust for price differences in order to have meaningful comparisons of GDP across countries. We need a conversion factor to get purchasing power equivalent.

If we take a shopping cart that includes all products and services and we use it as a reference point, we can calculate the price index for each country and by using the methods statistics, adjust the GDP index to solve the problem of differences in price levels.

That is exactly what purchasing power parity does. It is implemented by the ICP (International Comparison Program). Angus Deaton explains it this way: “Purchasing power parity conversion ratio, or PPP, is a price index that summarizes prices in each country relative to a benchmark country, usually the United States. These numbers are used to compare living standards across countries, by scholars in economic development, especially through the Penn World Table, of the World Bank – the organization that has structured it. this scale for global poverty levels, and the European Union’s redistribution of resources, as well as the international development community’s focus on disparities between rich and poor countries.”

As the figure below shows, using the PPP adjusted unit of measure for the international dollar instead of the market US dollar can make a huge difference. When prices are much lower in a country than in the United States, using the U.S. dollar in the foreign exchange market produces a significantly lower estimate of the standard of living when measured in terms of GDP per capita.

That colored line below is India’s GDP per capita in US dollars. And the red line above is GDP per capita in PPP (international dollars). The difference in 2016 of these two indexes is about 3.5 times.

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## Why is the difference in the price level not reflected in the foreign exchange (currency) market?

For two countries – A and B – currency differences allow for differential comparisons. The exchange rate tells you how many units of country B’s currency are needed to buy one unit of country A’s currency. The purchasing power parity conversion factor, on the other hand, provides a calculation of the relationship. relative price relationships between countries and allows for comparison when you want to know how much money is needed to buy the same quantity of goods and services in each country A and B.

So, why aren’t these two equivalent? This is not a trivial question. There are good reasons why exchange rates between two currencies should be reflects the relative price level between two economies. Imagine an apple costs 1 dollar in the United States and 1 pound in the UK. Assume the exchange market rate is not 1:1, but \$1.50 = £1. Given this situation, an American with apples would be motivated to sell apples in the UK, and then convert pounds into US dollars to generate a profit. This is what is called arbitrage. People will jump at such opportunities, and in the short term, market forces will be sucked into the gains from trade, leading to an equilibrium where currency and apple prices adjust and no longer have any opportunities to participate in this ‘free currency game’.

The logic above, however, must be based on the presumption that products and services are internationally tradable. But in reality there are goods and services that cannot be traded internationally. If you have a house in London, you can’t export it to the US or China (meaning one can’t clone physically, in the US you can live in a London home! And of course Americans or people in any other country if they have enough money they can completely buy a house in London.) There are many other examples of products that are not tradable, like public streets, for example, basic services like schools, or even more simple services like haircuts.

The point is that if you live in Scotland, you don’t care about tuition fees in Northern Italy, or the rent in Southern Spain. And this is important in the context of our discussion because the prices of non-tradable goods affect the country’s overall price level; but the price of non-tradable goods is determined primarily by domestic dynamics. That is one reason why we observe that differences in price levels across countries are not correspondingly reflected in differences in currency values.

## Why do rich countries tend to have higher prices?

We observe empirically that prices are higher in wealthier countries: there is a positive cross-country relationship between average income and average prices. That can be seen in the graph below, which outlines how GDP per capita (in international dollars) compares to prices (compared to the US). This observation was formalized by Balassa and Samuelson in the 1960s, and is often referred to as the ‘Penn effect’.

The causes behind the Penn effect are not simple; but economic theory offers some hints.

One possible explanation, which has received considerable attention in the academic literature, is based on productivity differences between countries; namely the fact that workers tend to be more productive in rich countries because they have more advanced technologies.

This is the essence of the ‘Balassa-Samuelson model’. The greater the differences in productivity in the production of tradable products between countries, the greater the differences in wages and prices of services; and correspondingly the large gap between purchasing power parity and exchange rate equilibrium. If the difference in international productivity is greater in the production of tradable goods than in the production of non-tradable goods, the more productive national currency will have tend to be overvalued in terms of purchasing power parity. Thus, the purchasing power parity ratio in exchange will increase as a function of income.

The correlation between productivity and price level can be observed in the scatter plot below.

The horizontal axis is purchasing power parity income in international dollars. The vertical axis is the level of prices relative to the United States.

## What is the biggest drawback of purchasing power parity (PPP) adjustment?

The last two rounds of PPP estimators were performed by ICP in 2005 and 2011; and the next is scheduled for 2017. With each release, estimates improve. But it is still important to remember the data limitations, especially if we consider the components: international organizations, charities and governments that rely on PPP elements to make policy design and allocation. international resources.

What is the biggest limitation?

First, there are problems with the underlying data sources used by the ICP. Many low-income countries do not collect complete data on price levels, so the ICP is often required to determine the missing value by making extrapolations based on regional averages, or by data from price levels in the capital of that country where prices are often higher than in rural areas.