Economists – especially those in the field of international relations – often toss around the term “purchasing power parity” to describe inconsistencies between economic measurements of different countries. This term is certainly technical, but is actually not that difficult to understand. Learning about the importance of purchasing power parity and how it impacts economic decision-making can provide critical background on international news stories and controversies.
Purchasing power parity is a way of accounting for the differences in inflation rates and pricing in different countries. Purchasing power is, in essence, the amount of goods one a person can purchase with a certain amount of money in his home country. Purchasing power parity refers to the price point at which the people in one country could purchase the same goods as the people in another country. In other words, it’s an economic adjustment that is based on what a good is worth in a hypothetical common currency.
The Law of One Price
The underlying principle of PPP is a concept called “the law of one price.” This is an economic assumption based on the notion that, all else being equal, the same goods in a global market should have the same price. The law of one price relies on the theory that goods of comparable quality and value to consumers will ultimately be driven by market prices to equilibrium. This assumption isn’t entirely safe for a series of reasons. Barriers to trade, inherent transportation costs, taxes and the inability of certain services to be imported and exported can all affect purchasing power parity.
Purchasing power parity is important for developing reasonably accurate economic statistics to compare the market conditions of different countries. For example, purchasing power parity is often used to equalize calculations of gross domestic product. Because purchasing power can vary from country to country, the statistic for GDP based on purchasing power parity is often different than nominal GDP – GDP as described by currency exchange alone.
Because purchasing power varies considerably, PPP provides insight on the potential overvaluation or undervaluation of a nation’s currency. This is important because currencies that are over or undervalued according to PPP are likely to correct over time, leading to potential economic impacts and long-term fluctuations in the exchange rate. PPP helps provide some predictability to these economic impacts. For example, a local currency determined by PPP to be significantly overvalued can be expected to depreciate against widely traded currencies like the U.S. dollar over the long run.