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Purchasing Power Parity (PPP) is a theory that measures prices at different locations using a common basket of goods. While PPP can be used to measure between two places using the same currency (like countries inside the Eurozone), its most common usage is between two locations that use different currencies. In that case, PPP produces an exchange rate that equals the ratio of the price of the basket of goods at one location over the price of the basket of goods at a different location. The PPP exchange rate may be different than the market exchange rate because of transportation costs, tariffs, and other frictions. PPP exchange rates are widely used when comparing GDP from different countries.WEB, Pakko, Michael, Burgernomics,weblink St. Louis Federal Reserve Bank, 24 August 2019,

## Concept

### Variations

There are variations to calculating PPP. The EKS method (developed by Ã–. Ã‰ltetÅ‘, P. KÃ¶ves and B. Szulc) uses the geometric mean of the exchange rates computed for individual goods.WEB, EKS Method,weblink OECD, The EKS-S method (by Ã‰ltetÅ‘, KÃ¶ves, Szulc, and Sergeev) uses two different baskets, one for each country, and then averages the result. While these methods work for 2 countries, the exchange rates may be inconsistent if applied to 3 countries, so further adjustment may be necessary so that the rate from currency A to B times the rate from B to C equals the rate from A to C.

### Relative PPP

Relative PPP is a weaker statement based on the Law of One Price, covering changes in the exchange rate and inflation rates. It seems to govern the exchange rate closer than PPP does.

## Usage

### Exchange Rate Prediction

PPP exchange rates are also valued because market exchange rates tend to move in their general direction, over a period of years. There is some value to knowing in which direction the exchange rate is more likely to shift over the long run.In neoclassical economic theory, the purchasing power parity theory assumes that the exchange rate between two currencies actually observed in the foreign exchange market is the one that is used in the purchasing power parity comparisons, so that the same amount of goods could actually be purchased in either currency with the same beginning amount of funds. Depending on the particular theory, purchasing power parity is assumed to hold either in the long run or, more strongly, in the short run. Theories that invoke purchasing power parity assume that in some circumstances a fall in either currency's purchasing power (a rise in its price level) would lead to a proportional decrease in that currency's valuation on the foreign exchange market.

### Identifying Manipulation

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.In 2011, the Big Mac Index was used to identify manipulation of inflation numbers by Argentina. Argentina responded by manipulating the Big Mac Index.

## Issues

### 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

## Examples

### Professional

#### 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

#### 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.

#### USB

The bank USB produces its "Prices and Earnings" report every 3 years. The 2012 report says, "Our reference basket of goods is based on European consumer habits and includes 122 positions".WEB, Prices and Earnings (Edition 2012),weblink UBS, 26 August 2019,

### Educational

To teach PPP, the basket of goods is often simplified to a single good.

#### Big Mac Index

File:Big Mac hamburger - Japan (3).jpg|thumb|Big Mac hamburgers, like this one from JapanJapanThe Big Mac Index is a simple implementation of PPP where the basket contains a single good: a Big Mac burger from McDonald's restaurants. The index was created and popularized by The Economist as a way to teach economics and to identify over- and under-valued currencies. The Big Mac has the value of being a relatively standardized consumer product that includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. There are some problems with the Big Mac Index. A Big Mac is perishable and not easily transported. That means the Law of One Price is not likely to keep prices the same in different locations. McDonalds restaurants are not present in every country, which limits the index's usage. Moreover, Big Macs are not sold at every McDonalds (noticeably in India), which limits its usage further.In the white paper, "Burgernomics", the authors computed a correlation of 0.73 between the Big Mac Index's prices and prices calculated using the Penn World Tables. This single-good index captures most, but not all, of the effects captured by more professional (and more complex) PPP measurement. The Economist uses The Big Mac Index to identify overvalued and undervalued currencies. That is, ones where the Big Mac is expense or cheap, when measured using current exchange rates. The January 2019 article states that a Big Mac costs HK\$20.00 in Hong Kong and US\$5.58 in the United States.NEWS,weblink The Big Mac index, 2019-01-10, The Economist, 2019-07-02, 0013-0613, The implied PPP exchange rate is 3.58 HK\$ per US\$. The difference between this and the actual exchange rate of 7.83 suggests that the Hong Kong dollar is 54.2% undervalued. That is, it is cheaper to convert US Dollars into HK\$ and buy a Big Mac in Hong Kong than it is to buy a Big Mac directly in US Dollars.

#### KFC Index

Similar to the Big Mac Index, the KFC Index measures PPP with a basket that contains a single item: a KFC Original 12/15 pc. bucket. The Big Mac Index cannot be used for most countries in Africa because most do not have a McDonalds restaurant. Thus, the KFC Index was created by Sagaci Research (a market research firm focusing solely on Africa) to identify over- and under-valued currencies in Africa. 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.

| \$1,094.11
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## References

{{Reflist}}

• weblink" title="web.archive.org/web/20100524214313weblink">"Understanding PPPs and PPP based national accounts" provides an overview of methodological issues in calculating PPP and in designing the ICP under which the main PPP tables (Maddison, Penn World Tables, and World Bank WDI) are based.
{{economics}}

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