What Does Purchasing Power Parity Mean?
- Purchasing Power Parity (PPP) is an international economics tool for describing the real cost of living in various countries. It is more accurate and descriptive of the cost of living than other statistics, such as gross domestic product (GDP) or the national median or mean of the GDP. It is also more useful in certain situations for determining the real value of money relative to the foreign exchange rate.
- PPP is often established by means of a particular PPP index. What a PPP index does is establish a formula comparing what it costs to purchase a certain basket of goods and services in different countries, thus taking into account both the cost of living and the rate of inflation. Different indices will use differing baskets of goods and services. PPP is based on the "law of one price," which states that all things being equal, market forces would establish the same price for goods and services everywhere. However, the law of one price only exists when the market is completely efficient, and issues like currency exchange, transportation costs, scarcity, tariffs and differing regulations do not exist. In actual practice, the law of one price has never and will never come into play, but the PPP attempts to approximate it. So, for example, according to a 2003 University of Pennsylvania study, the PPP of Bermuda was 54 percent above that of the US, meaning the real cost of living was more than half again higher than in the United States.
- The PPP is not a perfect tool. One of the most obvious problems is that not all countries share the same basket of indicative goods, even for staples. What a family in Myanmar would consider essential, for example, is radically different from what a Canadian family would. They both need food, but the emphasis on which types of food would be different; the Myanmar family would consume far less fuel and electronics. It is therefore hard to make absolute, universal projections using PPP methods.
- The two most approachable PPP indices are the Big Mac Index of the "Economist" magazine, and the iPod index of the Australian securities company CommSec. Neither is as scientific as a true PPP index should be, but both take a familiar item and calculate its real cost in varying locations. So, for example, if a Big Mac is more expensive in France than in the US, the degree should indicate the rough difference in the cost of living.
- Whenever someone claims that China is the world's second largest economy, they are using PPP calculations as the basis for that claim. According to strict GDP statistics, the world's second largest economy is still Japan. However, based on PPP calculations, the Chinese get more bang for their buck due to lower living costs. GDP per capita in China is $1,800 while on a PPP basis it is $7,204. Meanwhile, in Japan, the cost of living is much higher. The GDP per capita there is $37,600, but its PPP figure is only $30,615.
