What is the difference between GDP and PPP

Purchasing power parity

In this article we will explain to you what is called the Purchasing power parity understand and how to calculate them. We also go to that Purchasing power parity theory and purchasing power.

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Purchasing power parity definition

Purchasing power parity in short KKP or in English too PPP (purchasing power parity) abbreviated comes from the Macroeconomics and describes the situation in which two currencies have the same purchasing power, i.e. one can purchase the same shopping cart. If that is the case, then the real exchange rate is equal to 1.

Purchasing power parity theory simply explained

So it can be said that purchasing power parity is used to increase the Cost of living compare between two countries regardless of actual exchange rates of currencies. To understand what is behind the purchasing power parity theory and how it can be calculated, let's first look at one representative shopping cart. In this case, this is not a real shopping cart, but a compilation of a wide variety of goods that are available in almost all countries, such as 1 kg of sugar or a car. Due to the Jevon's law of indifference in prices the same manufactured products would have to have the same price in all countries.

If this were not the case, one could only make a profit by buying and selling goods at home and abroad on the basis of monetary values. Our purchasing power parity theory now states that fluctuations in Exchange rate between currencies in a hypothetical market, i.e. without customs duties and transport costs, until this price difference no longer exists and thus no Arbitrage profit more is possible.

In the foreign exchange market there is still the concept of Exchange rate parity. This shows the ratio of two currencies to one another or the ratio of one currency to a fixed reference value, for example gold or silver. This currency parity ensures a certain degree of security in trading across currency borders, since fixed exchange rates are price-neutral.

To make the whole thing a little clearer, we now come to a simple numerical example. Here we compare the cost of living in two economies, or how much can ultimately be consumed in the two countries.

Purchasing power parity example

Imagine your best friend has fulfilled his dream and works as a pastry chef in the USA. His monthly salary is $ 6,000. At a kilo price for sugar of $ 1, he can afford 6,000 kg of sugar. On the other side of the pond you also work as a pastry chef and earn € 8,000 a month. Now let's compare your two incomes. At an exchange rate of $ 1.11 / € you would have $ 8,880 per month. So you could say you are richer than your buddy because you have more dollars a month to spend. Unfortunately, sugar is more expensive here in Germany. Let's assume that sugar costs € 2 per kilo here - you can only afford 4,000 kg of sugar with your income.
You should now notice that this is less than your buddy even though you are richer.

Calculation of purchasing power parity

In order to be able to really compare the two of you, we calculate the KKP using the example of sugar. So we're comparing your salaries as if sugar cost the same in both countries. This is then called adjusted for purchasing power. To do this, we form the quotient from the domestic price and the foreign price, i.e.:

As you can see, this results in an exchange ratio of 2. We now use this exchange ratio instead of the exchange rate in order to be able to express your salary here in Germany in dollars.

So your salary would only be worth $ 4,000 after adjusting for purchasing power. This difference is due to the higher Price level in Germany. So we can say that your income here in Germany has a lower purchasing power than that of your friend in the USA. In short, because sugar costs twice as much in Germany as it does in the US, your money is only worth half as much.

According to the purchasing power parity theory, this should not actually be possible, because on an ideal, hypothetical market without Transaction costs the exchange rates between currencies should offset this difference. The theory also says that the Inflations in the currency areas in such a way that parity prevails. This is the case when the real exchange rate is equal to 1.

Purchasing power parity criticism

One of the criticisms of purchasing power parity theory is that it is derived from the law of equal prices, which requires that there can only be one single price for a good in a market. In reality, however, this poses many problems. Because different transport costs and customs duties or transaction costs lead to different prices for the same product, regardless of the currency used. Thus the purchasing power parity theory is only a simplified representation of reality.

Another point of criticism is that political factors such as strikes and election results as well as speculation in the foreign exchange market have an influence on the exchange rate, but these are neglected at the CPP.

Purchasing power parity conclusion

Finally, let's go briefly to the Big Mac Index a. This indicator compares the purchasing power of different currencies based on the price of a Big Mac and is a simple way to show undervaluation or overvaluation of individual currencies. The reason for this is that the burger has exactly the same ingredients and production techniques in all countries and is therefore the ideal comparative product.

Finally, it should be noted that the Purchasing power parity in reality not only refers to a single product, but to the shopping cart mentioned above. The more comparable goods there are, the easier it is to compare the purchasing power of the respective countries. According to the purchasing power parity theory, the exchange rate fluctuations between the currencies can be traced back to the different purchasing power of the currency.