Drawbacks of PPP - Deepstash

Drawbacks of PPP

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.

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MORE IDEAS FROM What Is Purchasing Power Parity (PPP)?

What is it used for ?

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.

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 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.

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What is PPP ?

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.

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Pairing PPP vs GDP

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.

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Calculating 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

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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.

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Gross Domestic Product (GDP)
  • This is the most basic indicator of the overall market value of a nation's finished domestic goods and services and the country's health and size.
  • There are two types of GDP: real and nominal. The former is the economic output after inflation is factored in while the latter does not take inflation into account.
  • The GDP is important because it gives us an idea of whether the economy of the country is growing or contracting.

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The Pizza Principle: Linking Fast Food With The Economy
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  • Inflation is a sustained increase in the general price level in an economy. Inflation means an increase in the cost of living as the price of goods and services rise.
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