The concept of Purchasing Power Parity is based on theory that a person holding one unit of specific currency is able to buy different quantities of goods in different countries. For example, a visitor to United States from another less developed country, holding \$100, will be limited in his buying potential as compared to what he could have bought from \$100, in his own country. Simply, it means that a unit of same currency is not equal in every country and buying potential of currency is limited to the purchasing power of that particular currency.

How is it Calculated?

The Purchasing Power Parity index, PPP, is calculated by comparing cost of basket of consumer goods in different countries. This basket of goods includes household and food items of common use. In a perfect scenario, identical goods should have the same price, no matter where that item is located. As this is not the case, PPP index strives to provide comparison of different countries based on what a standard basket of goods should cost in a particular country.

Purchasing Power of Unit of Currency

Theoretically, without transaction costs, if a standard basket of goods contains items (A, B, C and D) then the cost of that basket should differ in each country. Therefore, parity in purchasing power of a unit of currency may differ, substantially. Naturally, \$1 may mean nothing to an American or Canadian but it is commonly observed that whenever citizens of these countries land at airports in most less developed Asian or African countries, they are swarmed by porters demanding \$1. It is so because \$1 US or \$1 Canadian dollar has greater purchasing power than the local unit of currency.