Purchasing power parity

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Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century [1] and was developed in its modern form by Gustav Cassel in 1918.[2] The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets.

In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate.

The best-known and most-used purchasing power parity exchange rate is the Geary-Khamis dollar (the "international dollar").

PPP exchange rate (the "real exchange rate") fluctuations are mostly due to different rates of inflation between the two economies. Aside from this volatility, consistent deviations of the market and PPP exchange rates are observed, for example (market exchange rate) prices of non-traded goods and services are usually lower where incomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts than a dollar spent in the United States). Basically, PPP deduces exchange rates between currencies by finding goods available for purchase in both currencies and comparing the total cost for those goods in each currency.[3]

There can be marked differences between PPP and market exchange rates.[4] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[5]—considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, GDP per capita in India is about US$1,100 while on a PPP basis it is about US$3,000. This is frequently used to assert that India is the world's fourth-largest economy, but such a calculation would only be valid under the PPP theory, at nominal exchange rates its economy is only the eleventh largest. At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304.

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