Purchasing power parity
Because PPP exchange rates are more stable and are less affected by tariffs, they are used for many international comparisons, such as comparing countries' GDPs or other national income statistics.
This discrepancy has large implications; for instance, when converted via the nominal exchange rates, GDP per capita in India is about US$1,965[5] while on a PPP basis, it is about Int$7,197.
[6] At the other extreme, Denmark's nominal GDP per capita is around US$53,242, but its PPP figure is Int$46,602, in line with other developed nations.
The EKS method (developed by Ö. Éltető, P. Köves and B. Szulc) uses the geometric mean of the exchange rates computed for individual goods.
[7] The EKS-S method (by Éltető, Köves, Szulc, and Sergeev) uses two different baskets, one for each country, and then averages the result.
[8] Purchasing power parity exchange rate is used when comparing national production and consumption and other places where the prices of non-traded goods are considered important.
PPP exchange rates help costing but exclude profits and above all do not consider the different quality of goods among countries.
Also, different interest rates, speculation, hedging or interventions by central banks can influence the purchasing power parity of a country in the international markets.
It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals.
Measuring income in different countries using PPP exchange rates helps to avoid this problem, as the metrics give an understanding of relative wealth regarding local goods and services at domestic markets.
Using the above-mentioned example: in an international market, Mexicans can buy less than Americans after the fall of their currency, though their GDP PPP changed a little.
Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat more bread; Chinese more rice.
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.
In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries.
In 2011, interviewed by the Financial Times, a spokesperson for the IMF declared:[12] The IMF considers that GDP in purchase-power-parity (PPP) terms is not the most appropriate measure for comparing the relative size of countries to the global economy, because PPP price levels are influenced by nontraded services, which are more relevant domestically than globally.
Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it will not buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops.
The law of one price is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries.
[13] Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together.
According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP.
[15] The idea originated with the School of Salamanca in the 16th century, and was developed in its modern form by Gustav Cassel in 1916, in The Present Situation of the Foreign Trade.
[18] The stability of exchange rates was widely believed to be crucial for restoring the international trade and for its further stable and balanced growth.
Nobody then was mentally prepared for the idea that flexible exchange rates determined by market forces do not necessarily cause chaos and instability in the peaceful time (and that is what the abandoning of the gold standard during the war was blamed for).
Thus, PPP doctrine proposed by Cassel was not really a positive (descriptive) theory of exchange rate determination (as Cassel was perfectly aware of numerous factors that prevent exchange rates from stabilizing at PPP level if allowed to float), but rather a normative (prescriptive) policy advice, formulated in the context of discussions on returning to the gold standard.
[18] Each month, the Organisation for Economic Co-operation and Development (OECD) measures the differences in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates.
The OECD table below indicates the number of US dollars needed in each of the countries listed to buy the same representative basket of consumer goods and services that would cost US$100 in the United States.
The 2012 report says, "Our reference basket of goods is based on European consumer habits and includes 122 positions".
The index was created and popularized by The Economist in 1986 as a way to teach economics and to identify over- and under-valued currencies.
[24] The Big Mac has the value of being a relatively standardized consumer product that 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.
Consumer price index (CPI) and purchasing power parity (PPP) conversion factors share conceptual similarities.
