When dealing with different currencies it is important to be able to determine the relative value of each of them. Purchasing power parity (PPP) is a method for determining this comparative value. The theory behind PPP has been around since sixteenth century. It is based on the idea that if markets are effective, there will be the same price for items even if they are in different geographical locations — this is called the law of one price. Where differences do occur in price it can be due to barriers in trade and taxes. In reality there can be a huge difference between the prices of goods in different countries. These prices will also be impacted by things like level of supply and demand.
Purchasing Power Parity in the Real World
There are plenty of good examples in the real world that demonstrate how PPP works. The Economist magazine provided the most talked about example of PPP back in 1986. They compared the price of a Big Mac in 120 different countries. The aim was to use the PPP between the prices of this food item in different countries to determine what the actual exchange rate should really be. They found some interesting examples of PPP. For example, where comparing the price of a Big Mac between the UK and the United States they found that the burger was a lot more expensive in the UK. This implied the currency of the country was overvalued.
One of the main benefits of looking at purchasing power parity is it gives a much more realistic idea about Gross Domestic Product. As currencies fluctuate it creates a misleading picture of what is going on with the country’s GDP. It could be that while the GDP is growing on paper it doesn’t actually mean that the standard of living for people is improving. It is well known that GDP is not that reliable and this is why using PPP can provide a much clearer picture of what is going on when comparing two countries.
If we only use one item for PPP it is not going to be a very reliable indicator of what is going on with the relative value of currencies between two countries. In order to get a clearer picture it is necessary to use a number of different commodities that are relevant. A PPP that was only based on the price of the Big Mac would be of very limited value indeed.
Problems with PPP
There are a number of problems with determining exchange rates using PPP. One of the most notable of these is the fact that we aren’t always comparing like with like. For instance, if we have the price of shoes as a comparison we will be treating all shoes as if they were the same. This is obviously not the case as there can be a huge difference in how shoes are made and the quality of the materials used to put them together.
