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Purchasing Power Parity

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China Gears Up Preparations For 2008 Olympic Games
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Definition: Purchasing power parity (PPP) is an economic theory that states residents of one country should be able to buy the goods and services at the same price as residents of any other country over time. Why do economists say that? Because, ultimately, competition in international trade allows people to shop around for the best price. In other words, everyone's purchasing power will become equal, or reach parity. PPP is based on the law of one price. This states that once the difference in exchange rates is accounted for, then everything would cost the same. (Source: Journal of Economic Literature, Kenneth Rogoff, Purchasing Power Parity Puzzle, June 1996)

Of course, this isn't true in the real world on a day-to-day basis. Not everything can be traded as easily throughout the world, thanks to transportation costs, taxes and tariffs. Some things, like real estate and services such as haircuts, really can't be shipped. Not everyone throughout the world has the same access to international trade. For example, someone in rural China can't really choose between every good and service throughout the world. Perhaps one day Amazon.com and other online retailers will enable true purchasing power parity.

Purchasing power parity is also a calculation that determines how much things would cost if parity did exist. It takes into account the impact of exchange rates. It's calculated by determining what each item purchased in a country would cost if it were sold in the U.S. These are then added up for all the final goods and services produced in that country for that given year.

This parity is tedious to compute, since a U.S. dollar value has to be assigned to everything -- even items not widely available in the U.S. For example, would the price of an ox-cart in the U.S accurately describe its value in rural Vietnam, where it's mandatory to grow rice? What is the U.S. price equivalent of a haircut in a country where it's given by family members?

For many developing countries, the PPP is estimated using just a multiple of the official exchange rate (OER) measure. For developed countries, the OER and PPP measures of GDP are more similar, since their standards of living are closer to the U.S.

Applications of Purchasing Power Parity

Purchasing power parity is used in many situations. The most common is to adjust for the price differences between countries. For example, China produced $8.25 trillion in goods and services in 2012. The U.S. produced $15.66 trillion. However, you cannot compare the two without taking into account the fact that the cost of living in China is much lower than in the U.S. For example, a McDonald's Big Mac costs $4.37. In China, you can get the same thing for only $2.57. People in China don't need as much income because it costs less to live. (For more fun comparisons, see The Economist's Big Mac Index)

 

That's because China artificially sets the value of its currency to be lower than the U.S. dollar. It intentionally wants its cost of living to be lower, so it can pay its workers less. As a result, its exports cost less, making it more competitive on the global market.

Purchasing power parity solves the problem of comparing countries with different standards of living. It recalculates the value of a country's goods and services as if they were being sold at U.S. prices. Under PPP, a Chinese Big Mac costs $4.37, the same as it does in the U.S. As a result, China's GDP $12.38 trillion, which makes it the world's third largest economy, after the U.S. and the EU. That's why the CIA provides GDP estimates on both an official exchange rate and a purchasing power parity basis.

Without purchasing power parity, China's GDP per capita would only be $6,297, lower than the standard of living in Ukraine, Algeria or Kosovo. With PPP, each of the 1.3 trillion people receive (on average) the benefit of $9,100 in economic production. This is better, but still only on the level of Jamaica and worse than Cuba. It's far less than the U.S. GDP per capita of $47,400. That's because the U.S. can divide its GDP among only 330 million people. (Source: CIA Factbook)

Although this doesn't happen very often, PPP is also used to set the exchange rate for new countries. It is used to forecast future real exchange rates. Article updated March 27, 2012

Also Known As: PPP

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