Purchasing power parity (PPP) is an economic theory that states that
the exchange rate between two countries is equal to the ratio of the
currencies' respective purchasing power. Theories that invoke
purchasing power parity assume that in some circumstances (for
example, as a long-run tendency) it would cost exactly the same number
of, for example, US dollars to buy euros and then to use the
difference in value to buy a market basket of goods as it would cost
to directly purchase the market basket of goods with dollars. A fall
in either currency's purchasing power would lead to a proportional
decrease in that currency's valuation on the foreign exchange market.
The concept of purchasing power parity allows one to estimate what the
exchange rate between two currencies would have to be in order for the
exchange to be at par with the purchasing power of the two countries'
currencies. Using that PPP rate for hypothetical currency conversions,
a given amount of one currency thus has the same purchasing power
whether used directly to purchase a market basket of goods or used to
convert at the PPP rate to the other currency and then purchase the
market basket using that currency. Observed deviations of the exchange
rate from purchasing power parity are measured by deviations of the
real exchange rate from its PPP value of 1.
PPP exchange rates help costing but exclude profits. So, it is
reckoned as more efficient methodology than the use of market exchange
rates. For example, suppose that two countries produce the same
physical amounts of goods as each other in each of two different
years. Since market exchange rates fluctuate substantially, when the
GDP of one country measured in its own currency is converted to the
other country's currency using market exchange rates, one country
might be inferred to have higher real GDP than the other country in
one year but lower in the other; both of these inferences would fail
to reflect the reality of their relative levels of production. But if
one country's GDP is converted into the other country's currency using
PPP exchange rates instead of observed market exchange rates, the
false inference will not occur. Essentially GDP PPP controls for the
different costs of living and price levels, usually relative to the
United States Dollar, thus enabling a more accurate depiction of a
given nation's level of production.
3.1 Law of one price
Big Mac Index
3.3 iPad Index
3.6 OECD comparative price levels
3.7 Measurement issues
4 Need for adjustments to GDP
4.1 Extrapolating PPP rates
5.1 Range and quality of goods
Trade barriers and nontradables
5.3 Departures from free competition
5.4 Differences in price level measurement
6 Global poverty line
7 See also
9 External links
The idea originated with the
School of Salamanca
School of Salamanca in the 16th century,
and was developed in its modern form by
Gustav Cassel in 1916, in The
Present Situation of the Foreign Trade. 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
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
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. For example,
the World Bank's World Development Indicators 2005 estimated that in
Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan
by purchasing power parity—considerably different from the
nominal exchange rate. This discrepancy has large implications; for
instance, when converted via the nominal exchange rates GDP per capita
India is about US$1,965 while on a PPP basis it is about
US$7,197. At the other extreme, for instance Denmark's nominal GDP
per capita is around US$53,242, but its PPP figure is US$46,602, in
line with other developed nations.
The purchasing power parity exchange rate serves two main functions.
PPP exchange rates can be useful for making comparisons between
countries because they stay fairly constant from day to day or week to
week and only change modestly, if at all, from year to year. Second,
over a period of years, exchange rates do tend to move in the general
direction of the PPP exchange rate and there is some value to knowing
in which direction the exchange rate is more likely to shift over the
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. Furthermore, the basket of goods
representative of one economy will vary from that of another:
Americans eat more bread; Chinese more rice. Hence a PPP calculated
using the US consumption as a base will differ from that calculated
using China as a base. Additional statistical difficulties arise with
multilateral comparisons when (as is usually the case) more than two
countries are to be compared.
Various ways of averaging bilateral PPPs can provide a more stable
multilateral comparison, but at the cost of distorting bilateral ones.
These are all general issues of indexing; as with other price indices
there is no way to reduce complexity to a single number that is
equally satisfying for all purposes. Nevertheless, PPPs are typically
robust in the face of the many problems that arise in using market
exchange rates to make comparisons.
For example, in 2005 the price of a gallon of gasoline in Saudi Arabia
was USD 0.91, and in Norway the price was USD 6.27. 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. More comparisons have to be made and
used 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.
Law of one price
Although it may seem as if PPPs and the law of one price are the same,
there is 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
The purchasing power parity theory states that the exchange rate
between one currency and another currency is in equilibrium when their
domestic purchasing powers at that rate of exchange are equivalent.
Big Mac Index
Big Mac Index
Big Mac hamburgers, like this one from Japan, are similar worldwide.
Another example of one measure of the law of one price, which
underlies purchasing power parity, is the
Big Mac Index, popularized
by The Economist, which compares the prices of a
Big Mac burger in
McDonald's restaurants in different countries. The
Big Mac Index
Big Mac Index is
presumably useful because although it is based on a single consumer
product that may not be typical, it is a relatively standardized
product that 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.
In theory, the law of one price would hold that if, to take an
example, the Canadian dollar were to be significantly overvalued
relative to the U.S. dollar according to the
Big Mac Index, that gap
should be unsustainable because Canadians would import their Big Macs
from or travel to the U.S. to consume them, thus putting upward demand
pressure on the U.S. dollar by virtue of Canadians buying the U.S.
dollars needed to purchase the U.S.-made Big Macs and simultaneously
placing downward supply pressure on the Canadian dollar by virtue of
Canadians selling their currency in order to buy those same U.S.
The alternative to this exchange rate adjustment would be an
adjustment in prices, with Canadian McDonald's stores compelled to
lower prices to remain competitive. Either way, the valuation
difference should be reduced assuming perfect competition and a
perfectly tradable good. In practice, of course, the
Big Mac is not a
perfectly tradable good and there may also be capital flows that
sustain relative demand for the Canadian dollar. The difference in
price may have its origins in a variety of factors besides direct
input costs such as government regulations and product
However, in some emerging economies, Western fast food represents an
expensive niche product priced well above the price of traditional
Big Mac is not a mainstream 'cheap' meal as it is
in the West, but a luxury import. This relates back to the idea of
product differentiation: the fact that few substitutes for the Big Mac
are available confers market power on McDonald's. For example, in
India, the costs of local fast food like vada pav are comparative to
Big Mac signifies in the U.S. Additionally, with
countries like Argentina that have abundant beef resources, consumer
prices in general may not be as cheap as implied by the price of a Big
The following table, based on data from The Economist's January 2013
calculations, shows the under (−) and over (+) valuation of the
local currency against the U.S. dollar in %, according to the Big
Mac index. To take an example calculation, the local price of a Big
Mac in Hong Kong when converted to U.S. dollars at the market exchange
rate was $2.19, or 50% of the local price for a
Big Mac in the U.S. of
$4.37. Hence the Hong Kong dollar was deemed to be 50% undervalued
relative to the U.S. dollar on a PPP basis.
Country or region
Price level (% relative to the US)
0 (by definition)
Big Mac Index, the iPad index (elaborated by CommSec)
compares an item's price in various locations. Unlike the Big Mac,
however, each iPad is produced in the same place (except for the model
sold in Brazil) and all iPads (within the same model) have identical
performance characteristics. Price differences are therefore a
function of transportation costs, taxes, and to a lesser extent, the
prices that may be realized in individual markets. An iPad will cost
about twice as much in Argentina as in the United States.
Country or region
Price (US Dollars)
Canada (no tax)
United States (no tax)
Similar to the
Big Mac Index, the
KFC Index measures PPP amongst
African countries, created by Sagaci Research (a market research firm
focusing solely on Africa). Instead of comparing a Big Mac, this index
KFC Original 12/15 pc. bucket.
For example, the average price of KFC’s Original 12 pc. Bucket in
United States in January 2016 was $20.50; while in Namibia it was
only $13.40 at market exchange rates. Therefore, the index states the
Namibian dollar was undervalued by 33% at that time.
GlobalPetrolPrices has published two world rankings comparing gasoline
prices with average income and minimum wages.
OECD comparative price levels
Each month, the Organisation for Economic Co-operation and Development
measures the difference in price levels between its member countries
by calculating the ratios of PPPs for private final consumption
expenditure to exchange rates. The OECD table below indicates the
number of US dollars needed in each of the countries listed to buy the
same representative basket of consumer goods and services that would
cost 100 USD in the United States
According to the table, an American living or travelling in
Switzerland on an income denominated in US dollars would find that
country to be the most expensive of the group, having to spend 62%
more US dollars to maintain a standard of living comparable to the US
in terms of consumption.
Price level (US = 100)
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 not commercially available in Thailand and rice
is not in Ethiopia, 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
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 do 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
Need for adjustments to GDP
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 associated
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 US dollar, the Mexican
Gross Domestic Product
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. Similarly, when exchange rates deviate
significantly from their long term equilibrium due to speculative
attacks or carry trade, a PPP exchange rate offers a better
alternative for comparison.
Extrapolating PPP rates
Since global PPP estimates—such as those provided by the ICP— are
not calculated annually, but for a single year, PPP exchange rates for
years other than the benchmark year need to be extrapolated. One
way of doing this is by using the country's GDP deflator. To calculate
a country's PPP exchange rate in Geary–Khamis dollars for a
particular year, the calculation proceeds in the following manner:
displaystyle textrm PPPrate _ X,i = frac textrm PPPrate _
X,b cdot frac textrm GDPdef _ X,i textrm GDPdef _ X,b
textrm PPPrate _ U,b cdot frac textrm GDPdef _ U,i textrm
GDPdef _ U,b
Where PPPrateX,i is the PPP exchange rate of country X for year i,
PPPrateX,b is the PPP exchange rate of country X for the benchmark
year, PPPrateU,b is the PPP exchange rate of the
United States (US)
for the benchmark year (equal to 1), GDPdefX,i is the
GDP deflator of
country X for year i, GDPdefX,b is the
GDP deflator of country X for
the benchmark year, GDPdefU,i is the
GDP deflator of the US for year
i, and GDPdefU,b is the
GDP deflator of the US for the benchmark year.
There are a number of reasons that 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:
Local, non-tradable goods and services (like electric power) that are
produced and sold domestically.
Tradable goods such as non-perishable commodities that can be sold on
the international market (like diamonds).
The more that 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. (See also 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 farther
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
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.
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." 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
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
inter-country differences in conditions on both the demand side (e.g.,
virtually no demand for pork in Islamic states) and the supply side
(e.g., whether the existing market for a prospective entrant's product
features few suppliers or instead is already near-saturated).
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. Over time, shifts in market structure
and demand will occur, which may invalidate relative PPP.
Differences in 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
Global poverty line
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. PPP exchange rates include data from the sales of
high end none poverty related items which skews the value of food
items and necessary goods which is 70 percent of poor peoples'
consumption. Angus Deaton argues that PPP indexes need to be
reweighted for use in poverty measurement; they need to be redefined
to reflect local poverty measures, not global measures, weighing local
food items and excluding luxury items that are not prevalent or are
not of equal value in all localities.
Business and economics portal
List of countries by GDP (PPP)
List of countries by GDP (PPP)
List of countries by GDP (PPP) per capita
List of IMF ranked countries by GDP, Includes IMF ranked PPP of 186
Measures of national income and output
Relative purchasing power parity
^ Cassel, Gustav (December 1918). "Abnormal Deviations in
International Exchanges". 28, No. 112 (112). The Economic Journal:
413–415. JSTOR 2223329.
^ 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.
^ Krugman and Obstfeld (2009). International Economics. Pearson
^ Daneshkhu, Scheherazade (18 December 2007). "China,
'40% smaller'". Financial Times.
^ 2005 World Development Indicators: Table 5.7 Relative prices and
exchange rates Archived 2007-02-23 at the Wayback Machine.
^ List of countries by past and future GDP (nominal)
^ List of countries by future GDP (PPP) per capita estimates
^ Taylor and Taylor, Alan and Mark (Fall 2004). "The Purchasing Power
Parity Debate" (PDF). Journal of Economic Perspectives. 18, Number 4:
^ "CNN/Money: Global gas prices".
^ a b c d e f g Krugman and Obstfeld (2009). International Economics.
Pearson Education, Inc. pp. 394–395.
Big Mac index". The Economist. Retrieved 2017-06-13.
Big Mac Index". The
Big Mac Index. Retrieved 2017-06-13.
^ Narasimhan, Anand; Dogra, Aparna (3 September 2012). "The case
study: Goli Vada Pav". Financial Times. Retrieved 30 April 2014.
^ "Interactive currency-comparison tool". The Economist.
^ Glenda Kwek. "Is the Aussie too expensive? iPad index says no". The
^ 23rd Sep 2013, CommSec Economic Insight: CommSec iPad
Index[permanent dead link]
Commonwealth Securities 23 September 2013
^ Liz Tay (September 23, 2013). "Here's How Much An iPad Costs In 46
Countries". Business Insider Australia.
Gasoline Affordability Ranking - GlobalPetrolPrices, 14
^ Buying gasoline on minimum wage - GlobalPetrolPrices, 23 August 2016
^ as of 14 Apr 2015 "Monthly comparative price levels". OECD. 14 April
^ Paul Schreyer and Francette Koechlin (March 2002). "Purchasing power
parities – measurement and uses" (PDF). Statistics Brief. OECD
(3). CS1 maint: Uses authors parameter (link)
^ Paul McCarthy. "Chapter 18: Extrapolating PPPs and Comparing ICP
Benchmark Results" (PDF). International Comparison Program. World
Bank. p. 29.
^ Thomas Pogge on Global Poverty
^ Price indexes, inequality, and the measurement of world poverty
Angus Deaton, Princeton University
Penn World Table
Purchasing power parities updated by Organisation of Cooperation and
Development (OECD) from OECD data
Explanations from the U. of British Columbia (also provides daily
updated PPP charts)
Purchasing power parities as example of international statistical
cooperation from Eurostat - Statistics Explained
World Bank International Comparison Project provides PPP estimates for
a large number of countries
UBS's "Prices and Earnings" Report 2006 Good report on purchasing
power containing a
Big Mac index as well as for staples such as bread
and rice for 71 world cities.
"Understanding PPPs and PPP based national accounts"[permanent dead
link] provides an overview of methodological issues in calculating PPP
and in designing the ICP under which the main PPP tables (Maddison,
Penn World Tables, and
World Bank WDI) are based.
List of Countries by Purchasing Power Parity since 1990 (World Bank)
Balance of payments
Depression (Great Depression)
General Theory of Keynes
Rate of profit
Economies of scale
Economies of scope
Expected utility hypothesis
General equilibrium theory
Returns to scale
Social choice theory
Supply and demand
Theory of the firm
Law and economics
Ancient economic thought
Austrian school of economics
Chicago school of economics
Notable economists and
thinkers within economics
Francis Ysidro Edgeworth
John Maynard Keynes
Robert Lucas Jr.
John von Neumann
Herbert A. Simon
Asia-Pacific Economic Cooperation
Economic Cooperation Organization
International Monetary Fund
Organisation for Economic Co-operation and Development