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## Uses

The purchasing power parity exchange rate serves two main functions. PPP exchange rates can be useful for making comparisons between countries because they stay fairly constant from day to day or week to week and only change modestly if at all, from year to year. Second, over a period of years, exchange rates do tend to move in the general direction of the PPP exchange rate and there is some value to knowing in which direction the exchange rate is more likely to shift over the long run.

## Measurement

### Law of one price

Although it may seem as if PPPs and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.The purchasing power parity theory states that the exchange rate between one currency and another currency is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

### Big Mac Index

| -58
| -54
| -50
| -47
| -45
| -45
| -42
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| -41
| -37
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| -34
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| -8
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| 0
United States >| 0 (by definition)
| +1
| +3
| +5
| +7
| +8
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| +12
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| +29
| +63
| +75
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| +108

| \$1,094.11
| \$506.66
| \$674.96
| \$618.34
| \$791.40
| \$525.52
| \$557.18
| \$467.36
| \$602.13
| \$602.52
| \$676.69
| \$725.32
| \$695.25
| \$688.49
| \$618.34
| \$715.54
| \$501.52
| \$679.64
| \$512.61
| \$630.73
| \$674.96
| \$501.56
| \$641.50
| \$473.77
| \$591.62
| \$683.08
| \$610.45
| \$655.92
| \$556.42
| \$550.00
| \$704.51
| \$688.49
| \$596.08
| \$525.98
| \$674.96
| \$674.96
| \$559.38
| \$576.20
| \$674.96
| \$706.87
| \$617.58
| \$538.34
| \$530.72
| \$656.96
| \$544.32
| \$638.81
| \$546.91
| \$499.00
| \$554.08

### KFC Index

Similar to the Big Mac Index, the KFC Index measures PPP amongst African countries, created by Sagaci Research (a market research firm focusing solely on Africa). Instead of comparing a Big Mac, this index compares a KFC Original 12/15 pc. bucket.For example, the average price of KFC's Original 12 pc. Bucket in the United States in January 2016 was \$20.50; while in Namibia it was only \$13.40 at market exchange rates. Therefore, the index states the Namibian dollar was undervalued by 33% at that time.

### OECD comparative price levels

Each month, the Organisation for Economic Co-operation and Development (OECD) measures the differences in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed in each of the countries listed to buy the same representative basket of consumer goods and services that would cost US\$100 in the United States.According to the table, an American living or travelling in Switzerland on an income denominated in US dollars would find that country to be the most expensive of the group, having to spend 62% more US dollars to maintain a standard of living comparable to the US in terms of consumption.{| class="sortable wikitable"! Country! Price level(US = 100)as of 14 Apr 2015 WEB,weblink OECD, 14 April 2015, Monthly comparative price levels,
| 123
| 99
| 101
| 105
| 67
| 59
| 128
| 71
| 113
| 100
| 94
| 78
| 52
| 111
| 109
| 109
| 94
| 96
| 84
| 112
| 66
| 102
| 118
| 134
| 51
| 73
| 63
| 75
| 84
| 109
| 162
| 61
| 121
| 100

### Measurement issues

In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program, which PPP estimates are based on, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories.Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is not commercially available in Thailand and rice is not in Ethiopia, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison.PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages.Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which do not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.

## Need for adjustments to GDP

{{multiple image| align = right| width = 400| direction = vertical}}The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market.The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the associated Penn effect reflects such a systematic bias in using exchange rates to outputs among countries.For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison. Similarly, when exchange rates deviate significantly from their long term equilibrium due to speculative attacks or carry trade, a PPP exchange rate offers a better alternative for comparison.

### Extrapolating PPP rates

Since global PPP estimatesâ€”such as those provided by the ICPâ€” are not calculated annually, but for a single year, PPP exchange rates for years other than the benchmark year need to be extrapolated.JOURNAL,weblink Purchasing power parities â€“ measurement and uses, Paul Schreyer and Francette Koechlin, March 2002, 3, Statistics Brief, OECD, One way of doing this is by using the country's GDP deflator. To calculate a country's PPP exchange rate in Gearyâ€“Khamis dollars for a particular year, the calculation proceeds in the following manner:WEB,weblink Chapter 18: Extrapolating PPPs and Comparing ICP Benchmark Results, World Bank, International Comparison Program, Paul McCarthy, 29, textrm{PPPrate}_{X,i}=frac{textrm{PPPrate}_{X,b}cdot frac{textrm{GDPdef}_{X,i}}{textrm{GDPdef}_{X,b}}}{textrm{PPPrate}_{U,b}cdot frac{textrm{GDPdef}_{U,i}}{textrm{GDPdef}_{U,b}}}Where PPPrateX,i is the PPP exchange rate of country X for year i, PPPrateX,b is the PPP exchange rate of country X for the benchmark year, PPPrateU,b is the PPP exchange rate of the United States (US) for the benchmark year (equal to 1), GDPdefX,i is the GDP deflator of country X for year i, GDPdefX,b is the GDP deflator of country X for the benchmark year, GDPdefU,i is the GDP deflator of the US for year i, and GDPdefU,b is the GDP deflator of the US for the benchmark year.

## Difficulties

There are a number of reasons that different measures do not perfectly reflect standards of living.

### Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:
1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
2. Tradable goods such as non-perishable commodities that can be sold on the international market (like diamonds).

### Departures from free competition

Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of inter-country differences in conditions on both the demand side (e.g., virtually no demand for pork in Islamic states) and the supply side (e.g., whether the existing market for a prospective entrant's product features few suppliers or instead is already near-saturated). According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Over time, shifts in market structure and demand will occur, which may invalidate relative PPP.

### Differences in price level measurement

Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.

## Global poverty line

The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. PPP exchange rates include data from the sales of high end non-poverty related items which skews the value of food items and necessary goods which is 70 percent of poor peoples' consumption.Thomas Pogge on Global Poverty Angus Deaton argues that PPP indices need to be reweighted for use in poverty measurement; they need to be redefined to reflect local poverty measures, not global measures, weighing local food items and excluding luxury items that are not prevalent or are not of equal value in all localities.Price indexes, inequality, and the measurement of world poverty Angus Deaton, Princeton University

## References

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