Purchasing Power Parity

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What is Purchasing Power Parity?

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.

Why use Purchasing Power Parity?

Among other factors, economist use PPP index to gauge prosperity and earning potential of residents of different countries. One of the problems with indicators like GDP and exchange rates is that they do not take into account the difference in cost of living in different countries. In contrast, GDP calculations based on Purchasing Power Parity is somewhat better indicator of living standards. Consequently, it is noticeable that in 2003, one dollar was equal to 7.6 Yuan but according to PPP standards, one dollar should have been equal to 1.8 Yuan. Similarly, Denmark's per capita income is $62,100. Instead, PPP calculations suggest that nominal GDP per capita of Denmark is $37,304.

US dollar and Canadian dollar

Comparing PPP index of United States and Canada provides useful insight into the probable cost of living in these two countries. The PPP index in Canada is 90% of US figures which means that two different persons living in United States and Canada, earning similar incomes, will usually enjoy better living standards in United States. It is because purchasing power of US dollar is more than the purchasing power of Canadian dollar. Nowadays, it is common to rely on PPP index to derive GDP per capita figures. For example, GDP per capita by PPP standards is approximately $46,000 in United States as compared to $38,000, in Canada. It also means that on average a Canadian citizen earns 10-15% less than a person living in United States.