Purchasing power parity is a method for comparing the various standards of living of different countries and through different times. It also allows economists to compare one nation’s economic productivity to another nation’s. This economic theory believes that it is possible to compare the various currencies of different countries by analyzing the cost of a basket of goods. The idea states that two currencies are at a fair market value to each other when the basket of goods becomes priced identically in the two countries.
There is a formula for calculating purchasing power parity. It is S= P1/P2. S stands for the exchange rate of a first currency against a second one. P1 is the symbol for the price of goods in the first currency. P2 symbolizes the price of goods in the second currency.
Coming up with a meaningful comparison of goods requires that a considerable range of services and goods should be analyzed. This requires gathering a great amount of information. To help make the process easier, the United Nations worked with the University of Pennsylvania in 1968 to establish the International Comparisons Program.
The purchasing power parity numbers which come from the ICP uses price surveys from around the world which compare and contrast costs for literally hundreds of different goods. These results give international economists the tools they need to create global growth and productivity estimates.
The World Bank compiles a special report on PPP once each three years to compare the nations of the world by both U.S. dollars and their PPP values. Both the OECD Organization for Economic Cooperation and Development and the IMF International Monetary Fund base their recommended policies and economic predictions on the purchasing power parity measurements.
Forex traders have also been known to employ PPP to scout for undervalued and overvalued currencies. Finally investors with foreign corporation stocks or bonds can consider these figures to forecast how exchange rate fluctuations will impact the economy of the country where their investments are based.
When individuals or companies employ PPP, they are utilizing it in place of the market determined exchange rates. This figure provides them with the quantity of currency required to purchase the basket of goods and services used in the equation. This means that inflation rates and cost of living ultimately determine a nation’s PPP.
Economists are also able to utilize purchasing power parity to determine which countries have the largest amount of purchasing power. To do this, they take the GDP gross domestic product of countries as a starting point. This is the aggregate dollar amount of every good and service a nation produces in a particular year. The number is among the preferred means of analyzing the economy of a country. Economists can determine this in either market exchange rates or PPP terms.
The PPP measurement will consider the costs of localized services and goods of a given nation as measured in U.S. prices. It contemplates both the inflation rates and the exchange rates in this calculation. The GDP using PPP demonstrates a citizen’s purchasing power compared to that of the citizen in another. Since a shirt will usually cost more in one nation than in the other one, purchasing power parity helps to make the calculation fairer. While the 2016 rankings for GDP by market exchange terms show the top five countries as the U.S., China, India, Japan, and Germany, when PPP is used, China ranks ahead of the U.S.