Purchasing Power Parity


Purchasing Power Parity
A popular metric to compare economic productivity and standards of living between countries and across time is Purchasing Power Parity (PPP). It is an economic theory which compares the currencies of different countries through a “basket of goods” approach. As per this concept, two currencies are said to be in equilibrium or at par when a basket of goods (considering the exchange rate) is priced for the same amount in both countries. Law of One Price (LOOP) is another economic theory that is closely related to PPP. It is calculated by using the formula:
S = P1/ P2
where, S is represented by currency 1’s exchange rate to that of currency 2’s
P1 denotes cost of good in currency 1
P2 denotes cost of good in currency 2
PPP is often referred as a difficult task considering the amount of data to be collected and the complexity involved in drawing comparisons. The International Comparison Program was established to facilitate this during the year 1968, which generates PPP based on a worldwide price survey by comparing the prices of various other goods. This data helps other international macroeconomists come up with estimates of growth and global productivity. The use of PPP is an alternative to using market exchange rates.
PPP exchange rates serve two functions majorly. Firstly, it can be useful for making comparisons between nations as they stay fairly constant after days and only vary modestly if at all, as years passes by. Secondly, exchange rates tend to move in a general direction over a period of years and there would be some value to knowing the direction of exchange rate’s shift in the long run.

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