Purchasing power parity

Purchasing power parity (PPP) is a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries' currencies. PPP is effectively the ratio of the price of a market basket at one location divided by the price of the basket of goods at a different location. The PPP inflation and exchange rate may differ from the market exchange rate because of tariffs, and other transaction costs.

The purchasing power parity indicator can be used to compare economies regarding their gross domestic product (GDP), labour productivity and actual individual consumption, and in some cases to analyse price convergence and to compare the cost of living between places. The calculation of the PPP, according to the OECD, is made through a basket of goods that contains a "final product list [that] covers around 3,000 consumer goods and services, 30 occupations in government, 200 types of equipment goods and about 15 construction projects".

Purchasing power parity (PPP) is an economic term for measuring prices at different locations. It is based on the law of one price, which says that, if there are no transaction costs nor trade barriers for a particular good, then the price for that good should be the same at every location. Ideally, a computer in New York and in Hong Kong should have the same price. If its price is 500 US dollars in New York and the same computer cost 2000 HK dollars in Hong Kong, PPP theory says the exchange rate should be 4 HK dollars for every 1 US dollar.

This makes PPP similar to the consumer price index (CPI). Per D. S. Prasada Rao, an economics professor at the University of New England (Australia), "The CPI measures differences in levels of prices of goods and services over time within a country, whereas PPPs measure the change in levels of prices across regions within a country."

Poverty, tariffs, transportation, and other frictions prevent the trading and purchasing of various goods, so measuring a single good can cause a large error. The PPP term accounts for this by using a basket of goods, that is, many goods with different quantities. PPP then computes an inflation and exchange rate as the ratio of the price of the basket in one location to the price of the basket in the other location. For example, if a basket consisting of 1 computer, 1 ton of rice, and half a ton of steel was 1000 US dollars in New York and the same goods cost 6000 HK dollars in Hong Kong, the PPP exchange rate would be 6 HK dollars for every 1 US dollar.

The name purchasing power parity comes from the idea that, with the right exchange rate, consumers in every location will have the same purchasing power.

The value of the PPP exchange rate is very dependent on the basket of goods chosen. In general, goods are chosen that might closely obey the law of one price. Thus, one attempts to select goods which are traded easily and are commonly available in both locations. Organizations that compute PPP exchange rates use different baskets of goods and can come up with different values.

The PPP exchange rate may not match the market exchange rate. The market rate is more volatile because it reacts to changes in demand at each location. Also, tariffs and differences in the price of labour (see Balassa–Samuelson theorem) can contribute to longer-term differences between the two rates. One use of PPP is to predict longer-term exchange rates.