Purchasing power parity

When making comparisons between countries which use different currencies it is necessary to convert values, such as national income (GDP), to a common currency.

This can be done it two ways:

  1. Using market exchanges rates, such as $1 = ¥200, or:
  2. Using purchasing power parities (PPPs)

Market exchange rates

Using market exchange rates creates two main difficulties:

Firstly, market exchange rates can quickly change, which artificially changes the value of the variable in question, such as GDP. For example, a one-month appreciation of the US$ by 5% against the Japanese Yen would reduce the dollar value of the Japanese economy by 5%. Clearly, this is more to do with changes in the exchange rate than changes in the underlying state of the Japanese economy.

Secondly, market exchange rates are determined by demand and supply of currencies, which reflect changes in imports and exports of traded goods and services. However, not all countries trade the same proportion of their income and output, so currency values are not determined on a consistent basis.

Purchasing power parity

The alternative to using market exchange rates is to use purchasing power parities (PPPs). The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good, or common basket of goods and services. Purchasing power is clearly determined by the relative cost of living and inflation rates in different countries. Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences.

For example, if we convert GDP in Japan to US dollars using market exchange rates, relative purchasing power is not taken into account, and the validity of the comparison is weakened. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.

The Big Mac Index

This index, devised by The Economist, calculates how many units of a local currency are needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much local currency is required.

For example, if 200 Japanese yen (¥) are required to buy a Big Mac in Tokyo, and $2 are required in New York, the ‘value’ of currencies are $1 = ¥100. This can be used to adjust  the value of Japanese GDP, so that if GDP in Japan is ¥100 trillion, its value will be $1 trillion.

PPPs and market exchange rates compared

The World Bank produces a report every three years comparing countries in terms of PPPs and US$. As can be seen, when PPPs are used, the gap between the richer and poorer countries is considerably narrowed.