What Is Purchasing Power Parity (PPP)?

The relative version of PPP is calculated as

​S=P1/P2

S= Exchange rate of currency 1 to currency 2

P1 = Cost of good X in currency 1

P2 = Cost of good X in currency 2

A meaningful comparison of prices across countries requires a wide range of goods and services. To facilitate this University of Pennsylvania and UN joined forces to establish International Comparison Program.

PPPs generated by the ICP have a basis from a worldwide price survey that compares the prices of hundreds of various goods and services. The program helps international macroeconomists estimate global productivity and growth.

 The World Bank releases a report that compares the productivity and growth of various countries in terms of PPP and U.S. dollars.

The International Monetary Fund and the Organization for Economic Cooperation and Development use weights based on PPP metrics to make predictions and recommend economic policy. These policies can have an immediate short-term impact on financial markets.

Also, Investors who hold stock or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment.

Accounting GDP for PPP value.

This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies.

To better understand, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would therefore be 15/10, or 1.5.

Some factors explain why PPP is not a good reflection of reality.

• Tax differences: Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another
• Government Intervention: Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.
• Market Competition: Goods might be deliberately priced higher in a country. Higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly keeping them artificially high.