Purchasing power parity

Investors, economists, and government officials monitor their nation’s purchasing power, which are the products and services that can be purchased with the money the government issues. For example, in January, the dollar might buy three containers of cottage cheese. Next June, the consumer might be able to buy only two for the same dollar. In this case, purchasing power is on the decline, and inflation might be a threat.

Globalization increases the importance of purchasing power parity (PPP) because economies are interconnected. PPP measures the purchasing power for essentially the same goods and services in one country to those in many other countries. PPP contributes to a balance of trade and acts as a tool for measuring the growth of prosperity.

Purchasing power parity helps set the value of a nation’s currency. It might take more euros to buy the same basket of goods as a dollar on one calendar date and fewer euros six months later. Currency conversion rates (the value of a currency) have to be adjusted to eliminate differences in price levels.

Background

International trade based on monetary policies rather than barter of goods developed in the sixteenth century. By the twentieth century, monetary-based trade had developed to its most sophisticated degree. Economists like Karl Gustav Cassel (1866-1945) and John Maynard Keynes (1883-1946) encouraged countries to measure their PPP in relation to their monetary exchange rates.

The Israeli shekel was measured at about 3.4 to the US dollar in 2012. By 2015, the shekel value grew to 3.9 to the dollar. People living in Israel were able to buy fewer goods, paying with dollars in 2015. The public bought more American imports, or at least paid lower prices for them using the shekel. One important factor in this change in currency rates is to encourage more American imports, though it nibbles at the quantity of goods manufactured or grown in Israel. The US economy benefits from PPP; Heinz ketchup priced in Israel is not much more than Israel’s Osem brand. Currency rate adjustments equalize purchasing power between countries for the same goods over time and more effectively measure a country’s economy than simply using purchasing power.

Followers of PPP use two measures called absolute and relative. The former simply factors in the currency exchange rates to measure the cost of the same basket of goods in the United States and another country. Relative PPP factors in inflation rates, adjustments in currency rates, and other factors to perfect PPP.

A popular PPP index is the retail price charged for McDonald’s Big Macs sold in various countries. Costs for ingredients (beef, bread, lettuce, cheese) vary from one country to another, as do labor, real estate, and exchange rates. More universally accepted are some 3,000 consumer products and services, 200 types of equipment, and fifteen construction projects, along with some thirty government jobs. This allows for unique goods sold in one country but not another: for example, curry powder is a substantial consumer good in India but not in the United States, where beef is more critical to measuring PPP.

Overview

PPP shows price relationships of a basket of products and services in ratio to the prices in national currencies in different countries.

PPP contributes to a country’s economy, as well as setting prices for the same goods sold globally. Intercountry monetary currencies are adjusted, valued, and pegged one to another based on PPP. This contributes to more effective measurements of a country’s gross domestic product (GDP). The GDP reveals insights into the economic status, growth, depletion, and overall living standard.

Governments can use tools like changing bank borrowing rates, resetting consumer and business interest rates, and taking more drastic actions like applying rent and price controls on essential industries, raising or lowering tariffs on imported goods, and increasing government subsidies as the United States does on coal and dairy products to affect PPP.

Investors might pull their money out of the markets if they are scared about inflation slowing sales of items like cars and houses essential to a well-oiled American economy. If consumer purchasing power declines because of high gasoline prices or food costs, consumers have less money to spend on cars, rent, and utilities and are less likely to buy a new home. A commonly accepted "basket of goods" is an important PPP measurement for a nation’s financial growth and stability. When PPP is greater in one country, other countries try to sell their goods and services there, affecting exports from one country and domestic affairs in another.

Many European nations have joined together in a single monetary system known as the Economic and Monetary Union (EMU). They also formed the Organisation for Economic Co-operation and Development (OECD) to promote policies improving economic and social well-being of people around the world. Eurostat is the statistics agency of the European Union which works with the OECD. The OECD computes PPPs by measuring and monitoring expenditures, prices, and volume of goods vis-à-vis currency valuations assessing GDPs of member countries. The value of PPP lies in its generating indices for intercountry economic research and policy analysis. Sharing a common currency across money countries does not necessarily result in a common price level.

The Republic of Türkiye had the most powerful economy in the Middle East in 2015. Yet, Türkiye’s PPP measuring purchasing power and GDP per capita was 47 percent below the European Union average. Turkish citizens had a significantly lower standard of well-being than Europeans. Its lira was weak, causing high prices for gasoline, vehicles, and other goods. Investors considered opportunities in Türkiye at best with cautious optimism, and EU members, who, at that time, were considering Türkiye for membership are used the PPP and political reasons to exclude Türkiye.

PPP is used to measure the extent of poverty in countries. The World Bank is using PPP to establish a global poverty threshold. This affects international monetary loans, economic investments through foreign aid programs, food supplement programs, refugee and asylum definitions, and other measurements as poverty profiles are adjusted. PPP is used to measure inflation expectations in Japan, and the measures can be applied in other countries.

Bibliography

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"Price Level Ratio of PPP Conversion Factor (GDP) to Market Exchange Rate." World Bank Group, 2023, data.worldbank.org/indicator/PA.NUS.PPPC.RF. Accessed 12 Jan. 2025.

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“What Is Purchasing Power Parity (PPP), and How Is It Calculated?” Investopedia, 31 July 2024, www.investopedia.com/updates/purchasing-power-parity-ppp. Accessed 12 Jan. 2025.