Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP)

Purchasing Power Parity takes the Law of One Price and scales it up to the macro level. The idea is that identical baskets of goods ought to cost the same once you convert them into a common currency. Boil that down to a single good and the implied PPP exchange rate is just PPP = price_A / price_B. Say a Big Mac runs R$ 25 in São Paulo and US$ 5 in New York. The implied PPP rate comes out to 5 BRL per USD, no matter what the market rate happens to be.

The best-known casual version is The Economist's Big Mac Index, launched in 1986, which stands in a single product for a whole consumer basket. The serious counterpart is the World Bank's International Comparison Program (ICP). Every six years it surveys thousands of prices across more than 200 economies and publishes the official PPP conversion factors. Why do gaps from PPP linger for decades? Non-tradable goods, transport costs, taxes and capital controls all keep them open. For that reason PPP works better as a long-run anchor than as a short-term forecasting tool.

Applications

The headline use is comparing GDP. On a PPP basis, China passed the US as the world's largest economy back in 2014 according to the IMF, even though in nominal USD it still trails by roughly 40%. The IMF, World Bank and OECD all report GDP both ways because PPP gives a truer read on living standards. A barber's haircut in São Paulo and one in Zürich are much the same service, yet market exchange rates value them worlds apart. You'll also find PPP behind cross-country salary benchmarking, poverty thresholds (US$ 2.15/day at 2017 PPP, per the World Bank) and HDI calculations.

FAQ

Why does the market rate differ from PPP? What markets actually price is tradable goods, capital flows and risk premia. Haircuts, rent and education don't enter the equation. The Balassa-Samuelson effect goes further, predicting that rich-country currencies look overvalued in PPP terms because their non-tradable sector is the more productive one.

Is the Big Mac Index reliable? It points the right way, but don't trust the exact figures. As a teaching device and a rough valuation signal it's hard to beat, though it leaves out wages, real estate costs and local taxes.

When should I use PPP vs nominal GDP? Reach for PPP when you're comparing welfare and living standards. Stick with nominal for financial flows, debt sustainability and the value of trade.