This purchasing power exchange rate equalizes the purchasing power of different 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").
PPP exchange rates (the "real exchange rate") fluctuations are mostly due to market exchange rates 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 usually lower where incomes are lower. (A 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.
There can be marked differences between PPP and market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity — much different than the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about 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's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.
If the actual spot rate is greater, it suggests that the £ is over-valued against the $. If the actual spot rate is less, it suggests that the $ is over-valued against the £.
For example if a "representative" consumption basket costs $1,500 in the U.S. and £1,000 in the UK the PPP exchange rate would be $1.50/£. If the actual spot rate was $1.80/£ this would indicate that the pound is overvalued by 20%, or equivalently the dollar is undervalued by 16.7%.
Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate.
where is the spot rate in Foreign Currency/Domestic Currency and is the price level in period t (foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasing power parity.
According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the USD should depreciate by 2% compared to the purchasing power of the EUR (equivalently the EUR will appreciate by about 2%)
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 CPI) based on relative GDPs. Neo-classical economics includes Balassa-Samuelson effect theory, which explains the PPP model adjustment giving the equilibrium CPIs.
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.
When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
Using market exchange rates to compare countries' standard of living or per capita Gross Domestic Product can give a very misleading picture. The exchange rate only reflects traded goods in contrast to non-traded ones. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market.
The PPP method is used as an alternative.
For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.
The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect).
More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Chinese currency is five times stronger than the currency exchange rate, it won't buy five times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced rice. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like China), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve. This is sometimes called exploitation.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a relatively cheaper factor of production than is available to factories in richer countries.
PPP calculations tend to overemphasise the primary sectoral contribution and underemphasise the industrial and service sectoral contributions to the economy of a nation.
A PPP exchange rate varies depending on the choice of goods used for the index (CPI). Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. Indeed, it may be hard to construct equivalent representative bundles for the consumption habits of very different societies. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another, see: consumer price index.
Differing levels of government involvement in social spheres further complicate development of good CPI baskets (and, consequently, PPP measurements). For example, in 1986, nominal GDP of the United States was almost 4 times larger than the nominal GDP of the Soviet Union (on a per capita basis). Direct comparison failed to capture, however, that the Soviet Union provided free secondary and higher education and free healthcare to all its citizens, whereas Americans had to pay for education and healthcare themselves. To properly account for differences in quality of life in this situation, the CPI basket would have to include these expenditures explicitly. More importantly, government subsidies can potentially have large effect on consumption levels (free higher education will result in more college graduates), making it difficult to choose weights for individual components of CPI.
Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the standards of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Even a PPP-adjusted measure of GDP per capita must be used with caution, for all the usual reasons that the GDP figure itself is limited (for instance, its inability to capture the surplus between subjective value and payment price).
For example, in 2002, the nominal GDP per capita in Japan was about US$40,000, while the equivalent PPP into a U.S. goods basket was estimated at $27,000. In the U.S., GDP per capita was about $36,400 (nominal and real if based on 2002 dollars). This means that the average U.S. citizen could enjoy slightly more consumption than the average Japanese (vastly more if private saving is removed from consumption income). However, it does not necessarily follow, that this implies a "higher standard of living" in the sense of "enjoying life" more; the U.S. has higher crime rates and less social cohesion than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences.
While per-capita income does not take into account inequalities in wealth distribution, neither does the PPP-scaled income.
Whether or not PPP holds is an ongoing controversy. The reasons why it might not hold are numerous. The strictest form of PPP requires that:
1. financial markets are perfect with no controls, taxes, transaction costs, etc;
2. goods markets are perfect with international shipment of goods able to take place freely, instantaneously and without cost;
3. there is a single consumption good common to everyone; or
4. the same commodities appear in the same proportions in each country’s consumption basket.
These assumptions are clearly unrealistic. Furthermore, the PPP hypothesis designates relative inflation differentials as the only source of exchange rate variations. However, at least in the short run, other non-monetary phenomena such as changes in relative prices as well as changes in the level and composition of output and consumption influences the supply and demand for foreign currency and thus the exchange rate.
Some studies have found little support for the PPP hypothesis. They found substantial deviations from the law of one price in the commodities markets. If the law of one price does not hold, then PPP is not likely to hold either. However, another series of studies finds that PPP does hold but with a considerable time lag. Some suggest that PPP is often violated in the short run but holds up well in the long run. Most tests done on longer periods or on high inflation economies provide stronger support for PPP. Despite disagreements over some specific points, the consensus emerging from the vast literature on the subject is that PPP in its relative form is generally valid, at least in the long run.
Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: The PPP exchange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.