PURCHASING POWER PARITY: SIGNIFICANCE IN ECONOMY

By
Prof R K Gupta
BE (Hons), MBA, FIE
Aravali Institute of Management
Jodhpur (Rajasthan)
E-mail : cityju@rediffmail.com / rkgupta_India@hotmail.com
URL : www.Geocities.com/rkgupta_india
 

PURCHASING POWER PARITY: SIGNIFICANCE IN ECONOMY

In economics, the theory of purchasing power parity (PPP) asserts that, in equilibrium, the exchange rate that will prevail between two countries will be that which equalizes the prices of traded goods in each country. Typically, the prices of many goods will be looked at, weighted according to their importance in the economy.

PPP exchange rates are useful for comparing living standards between countries. Actual exchange rates can give a very misleading picture of living standards. For example, if the value of the Mexican Peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this does not necessarily mean that Mexicans are any poorer — 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.

A simple and humorous example of a 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 restaurants in different countries. If a Big Mac costs $4 in the US and £3 in Britain, the PPP exchange rate would be £3 for $4. However, if in the scenario $1 could be traded for £1, the theory of PPP suggests that over time the real exchange rate will change to match the PPP exchange rate.

The Economist: The Hamburger Standard (based on Jan 15, 2003 data)
 

Purchasing Power Parity (PPP): is a measure of the relative purchasing power of different currencies. It is measured by the price of the same goods in different countries, translated by the FX rate (or exchange rate) of that country's currency against a "base currency".

How to read this table:
In this case, the goods is the Big Mac. For example, if a BigMac costs €2.75 in the countries that use Euro and costs $2.65 in US, then the PPP exchange rate would be 2.75/2.65 = 1.0377.
If the actual exchange rate is lower, then the BigMac theory says that you should expect the value of the Euro to go up until it reaches the PPP exchange rate. If the actual exchange rate is higher, then the BigMac theory says that you should expect the value of the Euro to go down until it reaches the PPP exchange rate.

The Over/Under valuation against the dollar is calculated as:

(PPP - Exchange Rate)
----------------------------------     x 100
Exchange Rate

Criticisms of PPP

Critics say it is wrong to assume that the prices of goods should be equal in all countries. People in different countries usually put different values on the same goods. What is a luxury goods in one country can be an ordinary daily goods in another country. PPP disregards this.

Take example of this:

In India a cup of coffee in Delhi costs say Rs 15 and same in NY in USA $1.5. The rupee exchange rate should be 15/1.5 = 10. But it is not so. The exchange rate is 45.It is important which commodities or services are compared. Luxury goods and value added services may give highly distorted picture.

The exchange rate says how much you can buy in another country with one unit of your own currency. But the PPP exchange rate has nothing to do with how much you can buy.

Most sources do not state the goods used to measure the PPP, which can be statistically deceptive and be used to weight the PPP for or against a given country by careful choice of goods.

Quality of Life and PPP

Even if a correct 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 quality 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. Thus, even a PPP-adjusted measure of GDP per capita must be used with caution, as it is only one component of quality of life.

For example, in 2002, the GDP per capita for Japan was about US$40,000 and the PPP was estimated as $27,000, while in the US, GDP per capita was about $27,500 and the PPP was $36,000. The US has higher crime rates and a greater extent of poverty and slums 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 judgment and individual preferences.

Per capita income also does not take into account inequalities in wealth distribution.

Statistics of India:

GDP: Purchasing power parity - $2.66 trillion (2002.)  GDP - real growth rate: 6% (2003)

GDP - per capita: Purchasing power parity (PPP) - $2,540 (2002) Actual: $450 {Per annum}

GDP - composition by sector:
agriculture: 25%
industry: 25%
services: 50% (2002)

Population below poverty line: 25% (2002)

It has been estimated that if compared to New York and Delhi , a typical Indian family would be more or less enjoying similar standard of living with monthly income of $ 5000 PM and INR 50000 ( $ 1110) PM , respectively. But this figure would sharply drop in a small North Indian town to INR 20,000 or $ 450 PM.

Prof R K Gupta
BE (Hons), MBA, FIE
Aravali Institute of Management
Jodhpur (Rajasthan)
E-mail : cityju@rediffmail.com / rkgupta_India@hotmail.com
URL : www.Geocities.com/rkgupta_india
 

Source : E-mail June 5, 2004

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