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Purchasing power parity

GDP per capita adjusted for Purchasing Power Parity (PPP) in the world, 2009
Purchasing Power Parity adjustment for the world (2003). The economy of the United States is used as a reference, and is set at 100. Bermuda has the highest index value at 154; this means that goods sold there are more expensive than in the US.

In economics, purchasing power parity (PPP) is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918.[1][2] The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.[3]

Another interpretation is that the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.

Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. The best-known purchasing power adjustment is the Geary–Khamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the Balassa–Samuelson theorem.

There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[4] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[5]—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US\$1,704.063[6] while on a PPP basis it is about US\$3,608.196.[7] This means that if calculated at nominal exchange rates, India has the tenth largest economy, while at PPP-adjusted rates, it has the fourth largest economy in the world. At the other extreme, Denmark's nominal GDP per capita is around US\$62,100, but its PPP figure is only US\$37,304.

PPP measurement

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was \$0.91 USD, and in Norway the price was \$6.27 USD.[8] The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. Further comparisons have to be made and utilized as variables in the overall formulation of the PPP.

When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

The Relationship Between PPP and the Law of One Price

Although it may seem as if PPP and the law of one price are the same, there is in fact a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.[3]

The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent.

Big Mac Index

Big Mac hamburgers, like this one from Japan, are similar worldwide.

An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known food whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government regulations, product differentiation, and prices of nonfood inputs.[3] Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few substitutes for the Big Mac allows McDonald's to have market power. Countries like Argentina make sure the Big Mac is underpriced in an attempt to control the index and make sure it doesn't contradict the official statistics.

Starbucks tall latte index

The Starbucks tall latte index is a variant of the Big Mac Index; it can give information regarding exchange rates similar to the Big Mac Index. The tall latte index was compiled in 2004, during which time both a Big Mac and tall latte cost \$2.80. The measures told the same story in most cases with the notable exception of Asia. According to the Big Mac index, the yen was 12% undervalued against the dollar, whereas it was 13% overvalued according to the tall latte index. Furthermore, the Chinese yuan was 56% undervalued based on the Big Mac index but neither significantly undervalued nor overvalued according to the Starbucks index.[9]

The following table, based on data from The Economist's 2004 calculations, shows the under (-) and over (+) valuation of the local currency against the dollar in %, according to the Starbucks tall latte index and the Big Mac index.

Country Starbucks tall latte index McDonald's Big Mac Index
Australia -4 -17
Britain +17 +23
Canada -16 -16
China -1 -56
Euro area +33 +24
Hong Kong +15 -45
Japan +13 -12
Malaysia -25 -53
Mexico -15 -21
New Zealand -12 -4
Singapore +2 -31
South Korea +6 0
Switzerland +62 +82
Taiwan -5 -21
Thailand -31 -46
Turkey +6 +5

Measurement Issues

In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program, which PPP estimates are based on, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories.

Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is impossible to find in Thailand and vice versa, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison.

PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages.

Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which is not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.

2005 ICP

The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (-42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of \$153 1985 International dollars, but Pritchett has persuasively argued that \$250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to only \$229.

Angus Deaton and Alan Heston have suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%.

Need for PPP adjustments to GDP

Gross domestic product (by purchasing power parity) in 2006

The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market.

The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries.

For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

Difficulties

There are a number of reasons why different measures do not perfectly reflect standards of living.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types:

1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
2. Tradable goods such as non-perishable commodities that can be sold on the international market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currency exchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products tend to trade close to the currency exchange rate. (For more details of why, see: Penn effect).

More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity, and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries.

The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the Balassa-Samuelson theory. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive.[3]

PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.

Trade Barriers and Nontradables

The law of one price, the underlying mechanism behind PPP, is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price. As transport costs increase, the larger the range of exchange rate fluctuations. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country."[3] They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago, which is certainly not the case.

Nontradables are primarily services and the output of the construction industry. Nontradables also lead to deviations in PPP because the prices of nontradables are not linked internationally. The prices are determined by domestic supply and demand, and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of nontradables rise, the purchasing power of any given currency will fall in that country.[3]

Departures from Free Competition

Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of differing demand conditions between countries. According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Overtime, shifts in market structure and demand will occur, which may invalidate relative PPP.[3]

Differences in Consumption Patterns and Price Level Measurement

Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.[3]

PPP and Global Poverty Lines

The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP.

The primary problem associated with this calculation lies in the fact that price indexes are weighted averages of prices, and both weights and prices could be incorrect. Individuals living at the poverty line may face prices that are different from the average national prices, but the ICP bases calculations on the average national prices. Furthermore, the expenditure patterns at the poverty line are substantially different from national expenditure patterns, and these expenditure patterns in the National Accounts provide the weights used for the consumption PPPs described by the ICP.

A recent study published in the American Economic Journal sought to address this issue by using poverty-weighted purchasing power parities, PPPPs or P4s. Household surveys are the distinguishing difference between P4s and P3s. The study found that the substitution of poverty weights for national accounts does not make a large difference to global poverty counts. It did find, however, that the method of calculating the global poverty line does make a large differences. When the global poverty line was calculated using the weighted average of fifty national poverty lines, the global poverty count was significantly lower than when the poverty lines from the fifteen poorest countries were used, which is the method used by the World Bank to calculate the global poverty line. Because the numbers of people in poverty are used as weights, this difference in outcomes based on calculation-method is explained by countries, such as India, with a large number of people living in poverty that are included in the fifty but not in the fifteen poorest. India has a large number of poor people and, by international standards, a low national poverty line. The global poverty line is much lower when India is included than when it is excluded.[10]

The study explains dollars were not used to calculate poverty lines because the structure of advanced economies is different from the structure of economies where the global poor live. For this reason, rupees were more appropriate. The study makes recommendations to others who wish to make international comparisons of living standards for how to measure different indexes for the 2005 calendar year and also how to update these indexes when the results of the 2011 ICP become available. Among these recommendations include methods of converting rupees to dollars (which may be done because many people would want to read this information in terms of dollars).

See also

 Business and economics portal

Notes

1. ^ Cassel, Gustav (December 1918). Abnormal Deviations in International Exchanges. 28, No. 112. The Economic Journal. pp. 413–415. JSTOR 2223329.
2. ^ Cheung, Yin-Wong (2009). "purchasing power parity". In Reinert, Kenneth A.; Rajan, Ramkishen S.; Glass, Amy Jocelyn et al.. The Princeton Encyclopedia of the World Economy. I. Princeton: Princeton University Press. p. 942. ISBN 978-0-691-12812-2. Retrieved 2 October 2011.
3. ^ a b c d e f g h Krugman and Obstfeld (2009). International Economics. Pearson Education, Inc..
4. ^ FT.com / World - China, India economies ‘40% smaller’:By Scheherazade Daneshkhu in London Published: December 18 2007 18:04
5. ^ 2005 World Development Indicators: Table 5.7 | Relative prices and exchange rates
6. ^ List of countries by past and future GDP (nominal)
7. ^ List of countries by future GDP (PPP) per capita estimates
8. ^ "Global Gas Prices," (March 2005) CNN Money. Accessed June 2011.
9. ^ "The Starbucks index. "Burgers or beans? A new theory is percolating through the foreign-exchange markets"". The Economist. (Jan 15th 2004). Retrieved 30 August 2011.
10. ^ Deaton and Dupriez (April 2011). American Economic Journal 3.

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