Quick Definition: Purchasing power parity is when the exchange rate is adjusted to allow for accurate comparisons of purchasing power.
Purchasing power parity (PPP) is a theory developed by Gustav Cassel, a Swedish economist, in 1918. It states that the exchange rate between two countries is in equilibrium when their purchasing power is the same. This means that the exchange rate should adjust so that consumers can buy the same basket of goods at home and abroad using the same amount of domestic currency.
For example, if a basket of goods in the UK is worth £100 and an identical basket of goods in the US is worth $150, the PPP rate will be £1: $1.50.
To understand why the same basket of goods would cost the same in different countries, consider an example of buying a tennis racket.
Suppose the racket is worth £100 in the UK, $120 in the US and the exchange rate is £1: $1.50, we can calculate that the racket would cost £100 in the UK but £80 in the US ($120/1.5). Therefore, consumers would be better off if they buy the racket in the US.
If many consumers decide to do that, demand for the US dollar will increase, because more consumers require the US dollar to buy the US racket. This will cause the US dollar to appreciate in respect to the British pound. Suppose now the exchange rate becomes £1: $1.20, we can calculate that US racket now costs £100 to buy ($120/1.2), which is the same as the UK.
In this case, we have purchasing power parity, as the tennis racket costs the same in both countries and consumers will not be better off wherever they choose to buy the racket.
This process also happens in other goods therefore, in theory, an identical basket of goods would always cost the same in different countries.
In reality, the market exchange rate is not always the same as the PPP rate, as exchange rates are affected by many factors such as speculation and government intervention to achieve different objectives.
Because the PPP rate is more stable over time and excludes the speculative aspect of market exchange rates, economists use it to compare the purchasing power and standard of living (e.g. Human Development Index) between different countries.
Exchange rate – The nominal rate at which one country’s currency can be traded for another.
Human Development Index – This is an index that is constructed by the United Nations Development Program and measures a country’s development based on access to healthcare and education as well as national income.
Speculation – A financial activity in which people buy and sell assets (e.g. stocks or property) in the hope of making a large profit but with the risk of a substantial loss.
Standard of living – The level of wealth and material comfort available to an individual.