Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating

the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing [1] power. It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries. Among other uses, PPP rates facilitate international comparisons ofincome, as market exchange rates are often volatile, are affected by political and financial factors that do not lead to immediate changes in income and tend to systematically understate the standard of living in poor countries, due to the BalassaSamuelson effect. The idea originated with the School of Salamanca in the 16th century and was developed in its modern [2][3] form by Gustav Cassel in 1918. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different [4] markets when the prices are expressed in the same currency. Another interpretation is that the difference in the rate of change in prices at home and abroadthe difference in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate. Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP-adjusted" and converted into common units. The best-known purchasing power adjustment is the GearyKhamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the BalassaSamuelson theorem. There can be marked differences between purchasing power adjusted incomes and those converted via [5] market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power [6] parity considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is [7] [8] about US$1,704.063 while on a PPP basis it is about US$3,608.196. At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is US$37,304.

Measurement
The PPP exchange-rate calculation is controversial because of the difficulties of finding [citation needed] comparable baskets of goods to compare purchasing power across countries. Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from

that of another; Americans eat more bread, Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs can provide a more stabile multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was $0.91 US, and in Norway the [9] price was $6.27 US. The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

elationship between PPP and law of one price

Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the [4] level predicted by PPP. The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent. [edit]Big

Mac Index

Big Mac hamburgers, like this one fromJapan, are similar worldwide.

Main article: Big Mac Index An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known food whose final price, easily tracked in

many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government [4] [10] regulations, product differentiation, and prices of nonfood inputs. . Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few substitutes for the Big Mac allows McDonald's to have market power. Countries like Argentina that have abundant beef resources see a structural underpricing in the Big Mac.

Definition of 'Purchasing Power Parity - PPP'

An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. The relative version of PPP is calculated as:

Where: "S" represents 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

Investopedia explains 'Purchasing Power Parity - PPP'

In other words, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency. For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate bars cost US$1.00.)
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purchasing power parity Definition The theory that, in the long run, identical products and services in different countries should cost the same in different countries. This is based on the belief that exchange

rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another. For example, consider a laptop computer thatcosts 1,500 Euros in Germany and an exchange rate of 2 Euros to 1 U.S. Dollar. If the same laptop cost 1,000 dollars in the United States, U.S. consumers would buy the laptop in Germany. If done on a large scale, the influx of U.S. dollars would drive up the price of the Euro, until it equalized at 1.5 Euros to 1 U.S. Dollar - the same ratioof the price of the laptop in Germany to the price of the laptop in the U.S. The theory only applies to tradable goods, not to immobile goods or local services. The theory also discounts several real world factors, such as transportation costs, tariffs and transaction costs. It also assumes there are competitive markets for the goods and services in both countries.

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