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PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach.
According to this concept, two currencies are in equilibrium or considered being at par—when a basket of goods is priced the same in both countries, taking into account the exchange rates.
PPP as a theoretical exchange rate allows you to buy the same amount of goods and services in every country.
Eg: If you want to live inexpensively and you can move to any country in the world, compare the prices of McDonald's Big Mac.
Government agencies use it to compare the output of countries that use different exchange rates.
The relative version of PPP is calculated as
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.
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