What is Purchasing Power Parity?

What if I tell you the 1 US $ = 17.74 ₹? You will say that I am wrong as US $ is hovering around ₹ 70. Well, there is two aspect to this, one is the market exchange rate and another is the Purchasing Power Parity (PPP) rate.

The PPP rate will help to compare the different economic productivity and cost of living among different countries at various times. Purchasing Power Parity is the theory which takes account of the basket of goods that are being produced in the country. As per this theory, the two currencies are equal when a basket of goods is priced the same in both countries. It means the cost of something in country A should be the same as that in the country B at the same time.

What is Purchasing Power Parity?

Purchasing Power Parity is the way of measuring economic variables among different countries in a way that the market exchange rate do not distort comparison. It will basically negate the effect of the currency market rate to derive the actual picture of the economy of the country.

So here you will get the same basket of goods in different currencies with the same rate. So the same goods can actually be purchased in either of the currency with the same amount of funds.

Most of the time, we measure the country’s currency using the market exchange rate. This method fails to reflect the reality of their relative levels of production. But if one country’s GDP is converted to other country’s currency based on the PPP exchange rate then the real picture will come as it covers different costs of living and price levels of different country.

The Purchasing Power Parity Theory

In any economy, to compare the prices across various countries, you must consider a wide range of goods and services. Now collecting this data of a wide range of goods and service that too for the various countries is a very cumbersome and difficult task. To overcome this issue, the International Comparison Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations. They did the worldwide price survey after considering a variety of goods and services.

How to Calculate Purchasing Power Parity

There is a simple formula for calculating PPP rate. The formula is:

The purchasing power parity depends on the one simple law of one price. It negates the impact of the different money exchange rates. Here is the simple formula for calculating PPP. Where :

S = Exchange rate of currency 1 to currency 2

P1 = Cost of goods and services in currency 1

P2 = Cost of goods and services in currency 2

Now let’s understand the PPP with the help of an example. We will take an example of Mc Donalds burger price in India and US. Why I am taking Mc Donalds as the quality of the burger is same across the globe. So it will be easy for us to compare the same product in different currency and country.

Let’s assume the price of the burger is $4 in US. Now the exchange rate of dollar vs rupee is around Rs. 70. So in that case, the burger price in India should be Rs. 280 (Rs. 70 X $4). But that is not the case in India. We can get the burger in India at around Rs. 60. Now let’s compare both the price with the help of the PPP formula shown above.

The PPP would be : 60/4=15. Means Rs. 15 per $ 1 PPP rate while the exchange rate is Rs. 70 per $ 1.

Here we have talked about just a burger but in real life there are lots of goods and services which are getting compared while calculating PPP.

World Bank published PPP rate every three years comparing various country’s currency against the US dollar. Below is the PPP rate comparison between Indian Rupee and US dollar from 1990 to 2017.

purchasing power parity

India’s Rank in Purchasing Power Parity

GDP can also be compare with PPP. There is a normal GDP calculation and there is a GDP based on the PPP calculation as well. Below is the list of top 10 countries based on the normal GDP for 2017 and 2018.

As you can see, India ranks at 6th position in year 2017 and 7th position in 2018 based on the normal GDP.

world bank PPP

Now let’s check the top 10 list as per the GDP (PPP) basis. Here you can see the position of India is at 3rd. So as per the GDP (PPP) India is at 3rd largest economy in the world.

GDP (PPP)

In 2017, the average market exchange rate between India and US is around Rs. 70, in contrast, the PPP rate for the same period is Rs. 17.74/dollar. Thus, the market exchange rate was 3.94 time the PPP exchange rate.

This tells us that in order to maintain a living standard in India equivalent to that of United States for $1000 per month, one would need to spend Rs. 17,740 per month. This is because, after considering all the prices, including the services like haircuts, taxi rides, restaurant meals, the price level in India is less than 1/4 that in the US.

India is relatively low price level market due to abundance of unskilled labor in India. Because of the high supply of such unskilled labor, their wages are low. Which drives down the prices of the goods and services produced by the country.

Secondly, such services are representing a large chunk of the overall consumption, there would be a higher impact on the overall cost of living.

Difference between PPP and GDP

GDP stands for Gross Domestic Product, the total economic output of the country. It is derive by total output divided by the number of people in the country. So you can get the average output per person for that country. In other ways, the average amount of money each person makes.

It is an absolute measure remains same for country to country. On the other hand, PPP is a relative measure, taking account of various goods and products to derive person’s standard of living within that country.

PPP means how much of a local goods a person can buy in their country. While the normal GDP is how much of an internationally traded goods a person can buy in their country.

Normal GDP estimates the economic performance of a whole country. While PPP compares the differences in living standards between countries.

Conclusion:

Purchasing Power Parity gives a close and real picture about the country’s economy. You will be surprised to see that the $1 = Rs. 17.74 while the exchange rate for $1 is around Rs. 70. So the next time when someone covert the salary from dollar to Indian rupee, multiply it with the PPP rate rather than the exchange rate.

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