Purchasing Power Parity – ForTrader.org Financial Magazine


What is purchasing power parity?

Purchasing Power Parity (PPP) – the ratio between several (more often between two: the main and base) national currencies of different countries of the world, which is established by their purchasing power for a certain set of goods and services.

Purchasing power parity can be calculated for a specific group of goods and services or for an entire public product.

According to theory purchasing power parityfirst voiced by Gustav Cassel, the change in the ratio of the exchange rates of the two countries is proportional to the change in the ratio between domestic prices and prices abroad, i.e .:

If the purchase rate of currency A to currency B exceeds purchasing power parity, then it is more profitable to purchase goods in country B and sell them in country A. This state of affairs increases the supply of goods in country A and the demand for goods in country B, which in turn gives rise demand for the currency of country B and supply of the currency of country A. And this gradually, according to market law, leads to the return of exchange rates to parity.

Why is purchasing power parity needed?

The main indicator of the economic development of a country or region is the gross domestic product. One of the options for calculating GDP is based on the use of coefficients for comparing the purchasing power of currencies, determined by the ratio of prices for a set (basket) of identical goods from different countries.

In form, purchasing power parity is similar to the exchange rate, it shows how many units of a given country’s currency must be spent to buy the same amount of goods and services that can be bought for a unit of another country’s currency in this other country, that is, it shows the purchasing power of the national currency.

Purchasing Power Parity is a statistical index calculated for international comparisons and calculations. The exchange rate is a real instrument of macroeconomic policy.

Despite the attractiveness and usefulness of certain provisions of the theory of purchasing power parity, on the basis of empirical observations, various researchers have found that, as a rule, the dynamics of the exchange rate and the PPP of currencies does not completely coincide in the short term, although there is a convergence of their trends when considering relatively long period. It is important to emphasize that the nominal exchange rates and the purchasing power parity of currencies have fundamentally different semantic contents and cannot be considered interchangeable.

Calculating purchasing power parity

Within the framework of international comparisons of the UN, 600-800 basic consumer goods and services, 200-300 basic investment goods and 10-20 typical construction projects are taken to calculate purchasing power parity. Then it is determined how much this set is worth in the national currency of a particular country at the prices of that country and in US dollars at US prices.

Using an example of purchasing power, the video will tell you.

In the meantime, there is no need to know about it. ”

Useful links on the topic

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