Purchasing Power Parity PPP

1
Purchasing Power Parity (PPP)

• (and a bit about the ICP)

2
The Questions

• How does one compare economic data between
  countries that is expressed in units of national
  currency?
• Baht vs peso rupiah vs rupee
• How should measures of production and GDP be
  converted into a common unit?

3
Why is this important?

• Basic uses of official statistics
• Make policywho gets what
• Guide investment decisions
• Enhance competitive markets
• Globalization of world economies requiring
  multilateral comparisons
• Individual countries no longer can operate in a
  vacuum

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Possible Answers

• Convert using market exchange rates (X-rates)
• Convert using Purchasing Power Parities (PPPs)

5
Why Use X-rates?

• X-rates will convert the GDPs to a common
  currency
• X-rates are easily understood being determined by
  the demand for the supply of currencies
• they are market prices for currencies
• X-rates are easily observed, cover all countries,
  readily available (newspapers) timely (daily
  rates)

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Why not use X-rates?

• X-rate converted GDPs are not consistent over
  time
• X-rates are only partially determined by the
  demand supply of currencies for international
  trade tourism
• X-rate fluctuations can make it appear that
  countries get richer or poorer almost
  overnight - even though there has been no change
  in the volume of production

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GDP of Japan as a percentage of the GDP of EU 15
(EU 15 100) average annual growth rates
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What Is PPP?

• Theory which states that exchange rates between
  currencies are in equilibrium when their
  purchasing power is the same in each of the two
  countries
• Exchange rates that eliminate the differences in
  price levels between countries

9
What Is PPP?

• At the PPP rate, one US dollar has the same
  purchasing power (i.e. can buy the same goods and
  services everywhere)
• PPP rates allow a standard comparison of real
  price levels between countries i.e., permits
  volume comparisons

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How can PPP be calculated? (1)

• Simple idea of PPP between two countries compare
  the price of a standard good or service or a
  good or service that is identical across
  countries
• Simple form price relative showing the ratio of
  the prices in national currencies of the standard
  good or service

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Famous Example Big Mac Index

• Basket single item and price- Big Mac
• Index (Big Mac PPP) Divide price of Big Mac in
  a country by dollar price of Big Mac in the US
  to get Big Mac PPP (US)
• Big Mac PPP is the conversion rate that would
  mean hamburgers cost the same in the US as in any
  other country

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Big Mac Index (2)

• Price of Big Mac in US2.71
• Price of Big Mac in JapanYen 262
• Dividing the yen price in Japan by the dollar
  price in US (262/2.71) gives a Big Mac PPP of
  96.7 yen

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Big Mac Index (3)

• Comparing actual exchange rate with its PPP is
  one test of whether the currency is undervalued
  or overvalued
• Relative difference between a Big Mac PPP of 96.7
  and actual exchange rate of yen 120 is 19
• This means that yen is undervalued

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Comparisons w/ PPP An example
Income inequality between worlds richest and
poorest
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Beyond the Big Mac

• From a single product in the basket to several
  representative products
• PPPs at the product level
• PPPs at the product group level
• PPPs at the aggregation level (GDP)

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Basic Objective of the ICP

• Provide International Comparisons of GDP and Per
  Capita Expenditures which requires
• Same definition of GDP
• Same unit of currency
• Same price levels

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What is the ICP?

• Global Survey of Prices
• Items comparable across countries, representative
  within
• Compute Purchase Power Parities for 155 sub
  classifications of GDP
• Global Review of GDP
• Estimate expenditures155
• GDP detailed expenditures used to weight detailed
  level PPPs to total GDP

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Uses of PPP

• Comparisons of GDP and GDP per capita
• Measuring economic welfare
• Measuring size of economies
• Measuring productivity
• Comparisons of price levels
• Intertemporal comparisons (current vs constant
  PPPs)

See Handout Statistics Brief (OECD)
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Summary

• Law of PPP- same goods same prices
• PPP rate- international price index used to
  convert national aggregates (e.g. GDP) into
  PPP-based aggregates that are comparable among
  all countries