Purchasing power parity (PPP) is a very important economic concept. It is used to determine relative values while contrasting currencies of two different countries. It is of utmost significance because the values of different currencies are different. The amount of goods that can be bought with one currency is very different from what can be bought using the second currency. The PPP concept attempts to bridge the gap by apportioning one single international unit of measurement. It determines the PPP costs in both the currencies and then equates them.
PPP determines Costs of Living
The PPP index is a very important tool in determining the cost of living in different countries. With this, the analyst can estimate the amount and quantity of goods and services one can buy in a country. Also, the relative worth of the currency can be determined using the PPP concept. The earnings of an individual may be lesser in a country, but he may have higher purchasing power, as his currency is favorably placed. Another individual may be earning more but be in a position to purchase less because the cost of living is higher in her country.
Determining Foreign Exchange Rates
The Purchasing power parity enables an analyst in determining effective foreign exchange rates. This way she can equate one currency with another. If one unit of currency is worth 10 units in the other, the rate of foreign exchange would be 10. But if the cost of buying an item in country 1 is X and the cost in country 2 is 3X, the effective foreign exchange rate would be 3.
Defining Poverty Rates
The PPP is extremely helpful in determining the poverty rates in different countries. Analysts first determine the poverty line. This is the threshold of income that is mandatory to maintain a passable standard of living in the country. All those individuals who do not make the minimum required money to sustain an adequate lifestyle are said to be living below the poverty line. Poverty rates are different for different countries. The PPP index helps determine the minimum rates of money needed. This also provides an understanding of a country’s economy. The more the number of poor in a country, the weaker is its economy.
Rectifying Trade Disparities
The purchasing power parity concept is extremely important for countries to correct their trade imbalances. Often, a country’s levels of exports are not in the same proportion as its imports. Analysts first contrast the country’s currency rate and its PPP. This way he is able to realign the currency with the actual number of goods that can be bought with the currency.