Purchasing Power Parity

The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the idea that, in an efficient market, identical goods must have only one price. A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. It is often used to compare the standards of living between countries, rather than a per-capita gross domestic products comparison at market exchange rates. Market exchange rates tend to fluctuate much more wildly than PPP exchange rates. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed.

The PPP exchange-rate calculation is controversial because of the difficulties of finding 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. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects. Using market exchange rates to compare countries' standard of living or per capita Gross Domestic Product can give a very misleading picture. The exchange rate only reflects traded goods in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market.