Understanding Purchasing Power Parity (PPP)
Purchasing Power Parity, or PPP, attempts to equalize the purchasing power of different currencies to derive an exchange rate. It is a way to compare the value of goods and services in different countries.
To simplify, PPP means that if you convert the currency of one country into another, the amount of goods and services that you can buy with that currency should be roughly the same in both countries.
The idea of PPP was developed by the Spanish economist Luis de Molina in the 16th century. The concept came into popular acceptance in the field of economics in the 20th century and today, it is widely used by policymakers, investors, and economists to understand the global economy and make trade and investment decisions.
How does PPP work?
PPP works by comparing the prices of a basket of goods and services in two different countries. The basket of goods and services typically includes items such as food, housing, transportation, and clothing. The idea is that if the same basket of goods and services has a different cost in different countries, then the exchange rate between those two countries should adjust to reflect those differences in price levels.
Suppose that the price of a basket of goods and services in Germany is €100, and the price of the same basket of goods and services in Japan is ¥10,000. Then the PPP exchange rate between the German euro and the Japanese yen would make €1 equivalent to ¥100. That would be the exchange rate that would make the prices of the basket of goods and services equal in both countries.
Purchasing Power Parity of Germany & India
To understand the PPP of Germany and India, let us assume that the cost of the basket of goods and services is $100 in Germany and ₹5000 in India.
Currently, 1 Euro = 88.79 INR. But for the sake of this example, let us round this to 90 INR.
So, if the exchange rate between the Euro and Indian Rupee is, hypothetically, 1 EUR = 90 INR, then the PPP exchange rate would be calculated by dividing the price level in Germany by the price level in India.
PPP exchange rate = (Price level in Germany / Price level in India)
= (100 EUR / 5000 INR) * (90 INR / 1 EUR)
= 1.8 INR/EUR
This means that the PPP exchange rate would make 1 Euro equal to 1.8 INR. Therefore, if the exchange rate is different from this value, it would indicate that the currency of one country is overvalued or undervalued compared to the other country. What does this mean? An overvalued means the respective country has cheaper imports and relatively expensive exports. This decreases domestic demand and encourages spending on imports, a practice harmful. Simply put, the businesses converting their foreign currency earnings suffer and so does domestic investment & employment because it cannot compete against the export value.
Importance of PPP
PPP is important for several reasons. First, it allows for a more accurate comparison of living standards between different countries. This is important for policymakers who want to determine the relative wealth and poverty of different countries and develop policies to reduce inequality.
Second, PPP is important for international trade. If exchange rates do not reflect the differences in price levels between different countries, it can lead to distortions in trade flows. For example, if a country’s currency is overvalued relative to its PPP exchange rate, its exports will be more expensive and its imports will be cheaper, which can lead to a trade deficit.
Finally, PPP is important for investors who are interested in investing in different countries. It can help identify the inflation rate of a country and is important for business.
Limitations of PPP
Despite its advantages, PPP does have limitations. One of the major limitations is that it assumes that the same basket of goods and services is available in all countries. However, this is not always the case, especially for goods and services that are specific to a particular country or region. For example, the cost of sushi in Japan will not be the same as in the United States because the quality and availability of fish are different in each country.
Another limitation of PPP is that it does not take into account non-tradable goods and services, such as haircuts or healthcare. Non-tradable goods and services are those that cannot be easily traded across borders because they are specific to a particular country or region. For example, healthcare costs in the United States are much higher than in many other countries, but this does not necessarily mean that the US dollar is overvalued according to PPP because healthcare is a non-tradable good.
PPP is an important economic concept that helps in comparing the cost of living, economic growth, and inflation rates between countries. It provides a more accurate and standardized way of comparing the purchasing power of different currencies.