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Purchasing power parity: Difference between revisions
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[[:en:Purchasing power parity|English Wikipedia | [[:en:Purchasing power parity|Current English Wikipedia Article]] | ||
[[Image:PPP2003.svg|thumb|400px|right|Purchasing Power Parity (PPP) of Gross Domestic Product for the countries of the world as of 2003. The economy of the United States is used as a reference, so that country is set at 100. Bermuda has the highest index value, 154, thus goods sold in Bermuda are 54% more expensive than in the United States.]] | [[Image:PPP2003.svg|thumb|400px|right|Purchasing Power Parity (PPP) of Gross Domestic Product for the countries of the world as of 2003. The economy of the United States is used as a reference, so that country is set at 100. Bermuda has the highest index value, 154, thus goods sold in Bermuda are 54% more expensive than in the United States.]] | ||
'''Purchasing power parity''' ('''PPP''') is an alternative measure of the wealth of nations based on the long-term equilibrium [[:en:exchange rate|exchange rate]] of two currencies to equalize their [[:en:purchasing power|purchasing power]]. Developed by [[:en:Gustav Cassel|Gustav Cassel]] in 1918,<ref>Gustav Cassel, "Abnormal Deviations in International Exchanges," in ''Economic Journal'', (December, 1918), 413-415</ref> it is based on the [[:en:law of one price|law of one price]]: the theory states that, in ideally efficient markets, identical goods should have only one price. | '''Purchasing power parity''' ('''PPP''') is an alternative measure of the wealth of nations based on the long-term equilibrium [[:en:exchange rate|exchange rate]] of two currencies to equalize their [[:en:purchasing power|purchasing power]]. Developed by [[:en:Gustav Cassel|Gustav Cassel]] in 1918,<ref>Gustav Cassel, "Abnormal Deviations in International Exchanges," in ''Economic Journal'', (December, 1918), 413-415</ref> it is based on the [[:en:law of one price|law of one price]]: the theory states that, in ideally efficient markets, identical goods should have only one price. | ||
This purchasing power SEM rate equalizes the purchasing power of different [[Currency|currencies]] in their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative ''cost of living'' and the ''inflation'' rates of different countries, rather than just a nominal [[gross domestic product]] (GDP) comparison. The best-known and most-used purchasing power parity exchange rate is the [[Geary-Khamis dollar]] (the "international dollar"). | This purchasing power SEM rate equalizes the purchasing power of different [[:en:Currency|currencies]] in their home countries for a given basket of goods. Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative ''cost of living'' and the ''inflation'' rates of different countries, rather than just a nominal [[gross domestic product]] (GDP) comparison. The best-known and most-used purchasing power parity exchange rate is the [[:en:Geary-Khamis dollar|Geary-Khamis dollar]] (the "international dollar"). | ||
PPP exchange rate (the "[[Exchange rate#Nominal and real exchange rates|real exchange rate]]") fluctuations are mostly due to market exchange rate movements. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are [[Penn effect|usually lower]] where incomes are lower. (A [[United States dollar|U.S. dollar]] exchanged and spent in [[India]] will buy more haircuts than a dollar spent in the [[United States]]). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. | PPP exchange rate (the "[[:en:Exchange rate#Nominal and real exchange rates|real exchange rate]]") fluctuations are mostly due to market exchange rate movements. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are [[Penn effect|usually lower]] where incomes are lower. (A [[:en:United States dollar|U.S. dollar]] exchanged and spent in [[India]] will buy more haircuts than a dollar spent in the [[:en:United States|United States]]). PPP takes into account this lower cost of living and adjusts for it as though all income was spent locally. In other words, PPP is the amount of a certain basket of basic goods which can be bought in the given country with the money it produces. | ||
There can be marked differences between PPP and market exchange rates. <ref>[http://www.ft.com/cms/s/0/36a2d566-ad82-11dc-9386-0000779fd2ac.html FT.com / World - China, India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04]</ref> For example, the [[World Bank|World Bank's]] ''World Development Indicators 2005'' estimated that in 2003, one [[United States dollar]] was equivalent to about 1.8 [[Renminbi|Chinese yuan]] by purchasing power parity <ref>[http://devdata.worldbank.org/wdi2005/Table5_7.htm 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates]</ref> — considerably different from the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, [[List of countries by GDP (nominal) per capita|GDP per capita]] in the [[People's Republic of China]] is about [[United States dollar|US$]]1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, [[Japan|Japan's]] nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615. | There can be marked differences between PPP and market exchange rates. <ref>[http://www.ft.com/cms/s/0/36a2d566-ad82-11dc-9386-0000779fd2ac.html FT.com / World - China, India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04]</ref> For example, the [[World Bank|World Bank's]] ''World Development Indicators 2005'' estimated that in 2003, one [[United States dollar]] was equivalent to about 1.8 [[:en:Renminbi|Chinese yuan]] by purchasing power parity <ref>[http://devdata.worldbank.org/wdi2005/Table5_7.htm 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates]</ref> — considerably different from the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, [[:en:List of countries by GDP (nominal) per capita|GDP per capita]] in the [[People's Republic of China]] is about [[:en:United States dollar|US$]]1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second-largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, [[:en:Japan|Japan's]] nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615. | ||
==Explanation== | ==Explanation== | ||
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===PPP equalization and the law of one price=== | ===PPP equalization and the law of one price=== | ||
The | The law of one price states that differing prices of a traded good will tend to equalize in the absence of [[tariff]]s, other [[:en:Trade barrier|barriers to trade]] and prohibitively high [[shipping]] rates. The law of one price can also be stated as: "In an [[efficient market]] all identical [[:en:product (business)|goods]] must have only one price." | ||
The PPP | The PPP hypothesis is that free trade of goods will align [[exchange rates]] with their PPP values. However, [[econometric]] analysis rejects this hypothesis, and gives a better prediction of the PPP/exchange rate relationship (the [[:en:consumer price index|CPI]]) based on relative GDPs. Neo-classical economics includes [[Balassa-Samuelson effect]] theory, which explains the PPP model adjustment giving the equilibrium CPIs. | ||
==PPP measurement== | ==PPP measurement== | ||
The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable [[Market basket|baskets of goods]] to compare purchasing power across countries. | The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable [[:en:Market basket|baskets of goods]] to compare purchasing power across countries. | ||
Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform [[price level]]; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a [[price index]]. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. | Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform [[price level]]; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a [[price index]]. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. | ||
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===Big Mac Index=== | ===Big Mac Index=== | ||
[[Image:McDonald's_BigMac_ja-3.jpg|thumb|right|[[Big Mac]] hamburgers, like this one from [[Japan]], are similar [[Big Mac#Nutritional values | world-wide]].]] | [[Image:McDonald's_BigMac_ja-3.jpg|thumb|right|[[Big Mac]] hamburgers, like this one from [[Japan]], are similar [[:en:Big Mac#Nutritional values | world-wide]].]] | ||
{{mainarticle|Big Mac Index}} | {{mainarticle|:en:Big Mac Index}} | ||
An example of one measure of PPP is the [[Big Mac Index]] popularized by ''[[The Economist]]'', which looks at the prices of a [[Big Mac]] burger in [[McDonald's Corporation|McDonald's]] restaurants in different countries. If a Big Mac costs [[United States dollar|USD]]$4 in the U.S. and [[Pound Sterling|GBP]]£3 in Britain, the PPP [[exchange rate]] would be £3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, 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. The Big Mac Index is inaccurate in certain cases because of the different market conditions that exist in differing McDonald's locations. For instance, a Big Mac in downtown [[Chicago, Il|Chicago]] is likely to be priced higher than one in [[Wisconsin]]. Such pricing differences existing in one country demonstrate the imperfection of the Big Mac Index. In addition, in some emerging economies western fast food represents an expensive niche product price well above the price of traditional staples - i.e. the [[Big Mac]] is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners. Although it is not perfect, the index still offers significant insight and an easy example to the understanding of PPP. | An example of one measure of PPP is the [[Big Mac Index]] popularized by ''[[The Economist]]'', which looks at the prices of a [[Big Mac]] burger in [[McDonald's Corporation|McDonald's]] restaurants in different countries. If a Big Mac costs [[United States dollar|USD]]$4 in the U.S. and [[Pound Sterling|GBP]]£3 in Britain, the PPP [[exchange rate]] would be £3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, 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. The Big Mac Index is inaccurate in certain cases because of the different market conditions that exist in differing McDonald's locations. For instance, a Big Mac in downtown [[Chicago, Il|Chicago]] is likely to be priced higher than one in [[Wisconsin]]. Such pricing differences existing in one country demonstrate the imperfection of the Big Mac Index. In addition, in some emerging economies western fast food represents an expensive niche product price well above the price of traditional staples - i.e. the [[Big Mac]] is not a mainstream 'cheap' meal as it is in the west but a luxury import for the middle classes and foreigners. Although it is not perfect, the index still offers significant insight and an easy example to the understanding of PPP. | ||
