How to Determine Purchasing Power Parity

Purchasing power parity calculates whether buying power is similar using different currencies.

The economic theory of purchasing power parity attempts to refine the true value of currency. Purchasing power parity seeks to find whether the purchasing power among the world's currencies is equal or not. To find whether purchasing power is equal, purchasing power parity compares the exchange rates with price levels. If purchasing power parity exists, then the exchange rates and price levels should be equal. To determine purchasing power parity, you can compare the exchange rate and price level between two countries.

Instructions

1. 

   The euro is the currency of the European Union.

   Select two countries for which you want to determine purchasing power parity. The purchasing power parity equation compares the prices in two different countries with two different currencies. To illustrate how to determine purchasing power parity, compare the U.S. dollar and the European currency, the euro.

2. Select a product available in both countries to compare. Economic analysts use a variety of strategies to gauge a true reading of the purchasing power parity between two currencies. One method is to select a single product that exists in both countries. Another common method is to compare the prices of a collection of several common products available in both counties. For simplicity, this example will look at the purchasing price parity between McDonald's Big Macs in both the European and the U.S. markets.

3. Find the price of the comparison product in both countries. According to currency information from "The Economist," the price of a Big Mac in the United States on July 16, 2009, was $3.57. On the same day, the price of a Big Mac in Europe was € 3.31.

4. Divide the larger price by the smaller price to calculate the ratio of the prices of the comparison products. The formula used to find purchasing price parity is the following: S = P1/P2

   The variables P1 and P2 represent the two prices we compare to calculate purchasing price parity. In the case of this example, substitute € 3.31 for P1 and $3.57 for P2.

   S = € 3.31/$3.57

   By dividing € 3.31 by $3.57 you get .9271. If you round up the figure, you arrive at .93, as illustrated below:

   .93 = € 3.31/$3.57

5. Compare the price ratio to the exchange rate between the two currencies of the countries you selected. According to "The Economist," the currency exchange between the dollar and euro was .7464 euro per dollar. This mismatch means that in terms of the U.S. dollar, the purchasing power between the dollar and euro is not equal, meaning that the euro has greater purchasing power than the U.S. dollar if you are buying Big Macs.

Tips & Warnings

• Prices may change as inflation runs its course , so make certain you use updated information for a more precise measure of purchasing power parity.

• Exchange rates may also change and may affect your purchasing power parity calculations.

References

• Organization for Economic Cooperation and Development: How are PPP's calculated?
• University of British Columbia, Sauder School of Business: How is PPP Caluclated?
• "Journal of Economic Perspectives"; The Purchasing Power Parity Debate; Alan M. Taylor and Mark P. Taylor; Fall 2004

Resources

• Organization for Economic Cooperation and Development: FAQ