Purchasing power parity

In economics, purchasing power parity (PPP) is a method used to calculate an alternative exchange rate between the currencies of two countries. The PPP measures how much a currency can buy in terms of an international measure (usually dollars), since goods and services have different prices in some countries than in others.

Application

A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to express these numbers in the same currency. Using actual exchange rates when making these comparisons can give a very misleading picture of living standards. The PPP method is used to as an alternative.

Related Topics:
Standard of living - Gross Domestic Product

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For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are any poorer; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.

Related Topics:
Mexican peso - US dollar - Gross Domestic Product

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PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

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