Purchasing power parity: the basics

In short: Purchasing power parity describes the idea that a given amount of money, once converted into another currency, should buy the same quantity of goods everywhere. It is used to compare incomes and economic output between countries more fairly.

In more detail: In reality, market exchange rates often differ considerably from purchasing power parity, because many goods are not traded internationally and prices vary widely locally. International organisations therefore calculate their own purchasing power parities.

In detail

• Law of one price: The basis is the assumption that an identical tradeable good should cost the same everywhere in the absence of trade barriers and transport costs.
• Absolute and relative versions: The absolute version compares price levels directly; the relative version states that exchange rates change over the long term in line with differences in inflation between countries.
• Basket of goods: For comparisons, the prices of a large and as comparable as possible basket of goods are collected in different countries.
• Big Mac Index: For decades, The Economist magazine has compared the prices of a well-known burger as a simplified, rather light-hearted illustration of the principle.
• Non-tradeable goods: Services such as haircuts or rents are usually cheaper in countries with low wage levels, which is why the overall price level there is often lower.
• GDP comparisons: Gross domestic product per head in purchasing power standards shows better than a comparison at market exchange rates what standard of living an income actually allows.
• Limitations: Differences in quality, consumption habits and taxes make the calculation difficult, so purchasing power parities are always estimates.
• Exchange rate forecasts: In the short term, purchasing power parity hardly explains exchange rate movements; as a long-term reference point, however, it is often used in research (wechselkurse-und-devisenmarkt, bruttoinlandsprodukt-bip).