Formula to Calculate Purchasing Power Parity (PPP)
Purchasing power parity refers to the exchange rate of two different currencies that are going to be in equilibrium and PPP formula can be calculated by multiplying the cost of a particular product or services with the first currency by the cost of the same goods or services in US dollars.
The “purchasing power parity” is a term used to explain the economic theory that states that the exchange rate of two currencies will be in equilibrium or at par to the ratio of their respective purchasing powers. The formula for purchasing power parity of country 1 w.r.t. country 2 can be simply derived by dividing the cost of a particular good basket (say good X) in country 1 in currency 1 by the cost of the same good in country 2 in currency 2.
A popular practice is to calculate the purchasing power parity of a country w.r.t. The US and as such the formula can also be modified by dividing the cost of good X in currency 1 by the cost of the same good in the US dollar.
Purchasing power parity = Cost of good X in currency 1 / Cost of good X in US dollar
Calculation of Purchasing Power Parity (Step by Step)
The PPP Formula can be derived by using the following four steps
- Step 1: Firstly, try to figure out a good basket or commodity which is easily available in both the countries under consideration.
- Step 2: Next, determine the cost of the good basket in the first country in its own currency. The cost will be reflective of the cost of living in the country.
- Step 3: Next, determine the cost of the good basket in the other country in its own currency.
- Step 4: Finally, the PPP formula of country 1 w.r.t country 2 can be computed by dividing the cost of the good basket in country 1 in currency 1 by the cost of the same good in country 2 in currency 2 as shown below.
Purchasing power parity = Cost of good X in currency 1 / Cost of good X in currency
Examples
Example #1
Let take the example of purchasing power parity between India and the US. Suppose an American visits a particular market in India. The visitor bought 25 cupcakes for Rs.250 and remarked that cupcakes are quite cheaper in India. The visitor claimed that on an average 25 such cupcakes cost $6. Based on the given information calculate the purchasing power parity between the two countries.
Given, Cost of 25 cupcakes in INR = Rs.250
Cost of 25 cupcakes in USD = $6
Therefore, the purchasing power parity of India w.r.t US can be calculated as,
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Purchasing power parity = Cost of 25 cupcakes in INR / Cost of 25 cupcakes in USD
= Rs.250 / $6
Calculation of Purchasing Power Parity of India w.r.t US will be,
Purchasing Power Parity of India w.r.t US = Rs.41.67 per $
Therefore, the purchasing power parity ratio of the exchange for cupcakes is USD1 = INR41.67.
Example #2
Let’s take another example to compute purchasing power parity between China and the US. In January 2018, a McDonald’s Big Mac costs $5.28 in the US, while the same Big Mac could be bought for $3.17 in China during the same period. Based on the given information calculate the purchasing power parity between the two countries.
[Exchange rate $1 = CNY6.76]
- Given, Cost of Big Mac in CNY = 3.17 * CNY6.76 = CNY21.43
- Cost of Big Mac in USD = $5.28
Below table shows data for the calculation of purchasing power parity between China and the US.
The calculation of Cost of Big Mac in CNY will be,
Cost of Big Mac in CNY = 3.17 * CNY 6.76 = CNY 21.43
Therefore, the purchasing power parity of China w.r.t US can be calculated as,
Purchasing power parity = Cost of Big Mac in CNY / Cost of Big Mac in USD
= CNY 21.43 / $5.28
Calculation of Purchasing Power Parity of China w.r.t US will be,
Purchasing Power Parity = CNY4.06 per $
Therefore, the purchasing power parity ratio of the exchange for Big Mac is USD1 = CNY4.06.
Purchasing Power Parity Calculator
You can use these Purchasing Power Parity Calculator
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Relevance and Use
It is very important to understand the concept of PPP formula because it is required to compare the national incomes and the standard of living of various nations. Hence, the metric of purchasing power parity between two countries represents the total number of goods and services that a single unit of the currency of one country will be able to purchase in another country, taking into consideration the price levels in both countries. Therefore, when the theory of purchasing power parity holds good, then this metric should be equal to unity.
Another major application of the purchasing power parity is in the calculation of the gross domestic product of a nation as it helps in offsetting the impact of inflation and other similar factors. The metric mitigates the problem of the large difference in inflation rates across nations and aid in the measurement of the relative outputs of various economies and their living standards. The variables based on purchasing power parity show the real picture, thus allowing comparison. As such, the purchasing power parity method plays a significant part and are preferred in the analyses that are carried out by researchers, policymakers, and other private institutions. The variables based on purchasing power parity do not show major fluctuations in the short run. In the long run, the metric exhibits somewhat variation which is indicative of the direction of movement of the exchange rate.
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