Purchasing power parity: Return of the Mac | The Economist Return of the Mac Tweet FOR more than 25 years, The Economist has been producing Big Mac indexes. At last, this burgernomics thing seems to be catching on. In a new paper , Orley Ashenfelter and Stepan Jurajda take the economic potential of the McDonald's menu a step further, adding to the mix wage data from stores around the world. This week's Free exchange column explores their results. First, a word about the economics underlying their analysis. Their work, like The Economist's Big Mac index, grapples with the tricky business of international price and wage comparisons. At its heart is the theory of purchasing-power parity (PPP). Economists reckon the price of a good should not vary much across efficient markets. Otherwise people would buy in cheap markets and sell in dear ones until prices equalised. PPP generalises this “law of one price”. Over the long run, it suggests, exchange rates should adjust so a basket of goods costs the same in different countries. If that basket is whimsically taken to contain only a Big Mac, then burger prices may be used for back-of-the-napkin currency valuations.

In January a Swiss Big Mac cost $6.81, compared with $4.20 in America and just $2.44 in China, hinting at an overvalued franc relative to the dollar and an undervalued yuan. Economists use PPP to provide better comparisons of welfare across countries than can be gleaned from simply converting wages at market exchange rates. Exchange rates should adjust so that workers making traded goods are paid according to their productivity. But firms that sell non-traded goods and services must compete with firms in the tradable-goods sector for labour. So a country with high-productivity exporting firms will have high wages across all sectors—including those, like hair-cutting, where productivity differences between rich and poor countries are small. As a result, the cost of living is higher in rich countries, and simple exchange-rate adjustments overstate real welfare differences. On an exchange-rate basis, the average American is 35 times richer than the average Indian. On a PPP basis, however, taking account of the lower cost of living in India, American income is just 13 times higher. Mssrs Ashenfelter and Jurajda collect wage data from McDonald's stores in over 60 countries (McWages).

Adjusting those wages for exchange rates provides an excellent comparison of the cost of hiring the labour needed to do simple, well-defined tasks. Then take those McWages and divide by the local price of a Big Mac and you have a surprisingly simple yet powerful measure of PPP-adjusted wages. Wage (and, therefore, productivity) gaps between rich and emerging economies remain large, but the welfare gaps, as measured by the PPP-adjusted "Big Macs per hour" measure, are a bit narrower. And getting narrower still, in part because of rich-world stagnation: Between 2000 and 2007 America's McWage rose by 13% while the Big Mac price jumped by 21%, resulting in a net tumble in the BMPH real wage of 7% (see chart, right panel). Meanwhile, the BRICs advanced as McWages grew faster than Big Mac prices. The BMPH jumped by 53% in India, 60% in China and 152% in a Russian economy recovering from financial crisis in 1998. The going has been slower since then. Russia and China managed gains from 2007 to 2011.

Most others did not, as food prices rose faster than McWages. Data gathered this summer for the 2012 calculations may show a further slowdown. Bad news for an emerging world still hungry for better living standards. One can derive an awful lot of insight from a burger. Purchasing Power Parity Purchasing Power Parity What is Purchasing Power Parity? Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. (2) There must be competitive markets for the goods and services in both countries. (3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries. Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP.

Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels across countries. Put formally, the exchange rate between Canada and the United States ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD. Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large. Does PPP determine exchange rates in the short term? No.

Exchange rate movements in the short term are news-driven. Announcements about interest rate changes, changes in perception of the growth path of economies and the like are all factors that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of currencies. This can take many years, however. A time horizon of 4-10 years would be typical. How is PPP calculated? The simplest way to calculate purchasing power parity between two countries is to compare the price of a "standard" good that is in fact identical across countries. Every year The Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a large number of goods and services. One of the key problems is that people in different countries consumer very different sets of goods and services, making it difficult to compare the purchasing power between countries. According to PPP, by how much are currencies overvalued or undervalued? The following two charts compare the PPP of a currency with its actual exchange rate relative to the US Dollar and relative to the Canadian Dollar, respectively.

The charts are updated periodically to reflect the current exchange rate. It is also updated once a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the Organization of Economic Cooperation and Development (OECD) and others; however, they should not be taken as "definitive". Different methods of calculation will arrive at different PPP rates. The currencies listed below are compared to the US Dollar. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the US Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the US Dollar in the long run. The currencies listed below are compared to the Canadian Dollar. A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Canadian Dollar in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the Canadian Dollar in the long run. The currencies listed below are compared to the European Euro.

A green bar indicated that the local currency is overvalued by the percentage figure shown on the axis; the currency is thus expected to depreciate against the Euro in the long run. A red bar indicates undervaluation of the local currency; the currency is thus expected to appreciate against the Euro in the long run. Where can I get more information? • OECD National Accounts : The OECD publishes PPPs for all OECD countries . You can retrieve a table with the OECD's 1950-2015 PPP rates . This is a comma-seprated file that can be easily imported into a spreadsheet program. • From The Economist magazine: The Big Mac Index - as they put it "The world's most accurate financial indicator (to be based on a fast food item), with a ten-year retrospective on burgernomics" • Wilfred J. Ethier: Modern International Economics, 3rd edition. W. W. Norton & Comp., New York/London: 1995.

Chapter 18, section 2 on "Price Linkages" contains an excellent non-technical overview of PPP • Kenneth Rogoff: The Purchasing Power Parity Puzzle, Journal of Economic Literature, 34(2), June 1996, pages 647-668. This recent survey provides an overview of developments with respect to research on PPP, including the emerging consensus that deviations from PPP do damp out but only very slowly, at roughly fifteen percent per year. It remains difficult to explain why the estimated speed of convergence to PPP is so slow. • For the more technically minded, I recommend searching the EconLit database for recent research papers on PPP. This is a very active branch of economic research, both theoretically and empirically. © 2016 by Werner Antweiler, University of British Columbia. All rights reserved. The Pacific Exchange Rate Service is located in Vancouver, Canada.

Purchasing Power Parity: Definition, How It's Used By Kimberly Amadeo Updated December 28, 2016 Definition: Purchasing power parity (PPP) is an economic theory that states residents of one country should be able to buy the goods and services at the same price as inhabitants of any other nation over time. Why do economists say that? International trade allows people to shop around for the best price . Given enough time, everyone's purchasing power will become equal, or reach parity. PPP depends on the law of one price. That states that once the difference in exchange rates is accounted for, then everything would cost the same. (Source: Journal of Economic Literature, Kenneth Rogoff, Purchasing Power Parity Puzzle , June 1996) That's not true in the real world on a day-to-day basis. That's because of differences in transportation costs , taxes, and tariffs . Some things, such as land and services (like haircuts), can't be shipped. Not everyone throughout the world has the same access to international trade. For example, someone in rural China can't choose between every good and service throughout the world. Perhaps one day Amazon.com and other online retailers will enable real purchasing power parity.

PPP Calculation Purchasing power parity is a calculation that determines how much things would cost if parity did exist. It takes into account the impact of exchange rates . It describes what each item purchased in a country would cost if it were sold in the United States. These are then added up for all the final goods and services produced in that country for that given year. Parity is tedious to compute. A U.S. dollar value must be assigned to everything. That includes items not widely available in America. For example, there aren't too many ox-carts in the United States. Would its U.S. price accurately describe its value in rural Vietnam, where it's needed to grow rice?What is the U.S. price equivalent of a haircut in a country where family members give it? For many developing countries , the PPP is estimated using just a multiple of the official exchange rate (OER) measure. For developed countries , the OER and PPP measures of GDP are more similar, since their standards of living are closer to the United States. How It's Used Purchasing power parity is used in many situations. The most common method is to adjust for the price differences between countries.

For example, China produced $10.98 trillion in goods and services in 2015. The U.S. produced $17.95 trillion. But you cannot compare the two without taking into account the fact that the cost of living in China is much lower than in the United States. For example, a McDonald's Big Mac costs $5.04. In China, you can get the same thing for only $2.79. People in China don't need as much income because it costs less to live. (For more fun comparisons, see The Economist's Big Mac Index ) That's because China artificially sets the value of its currency to be lower than the U.S. dollar . It intentionally wants its cost of living to be lower, so it can pay its workers less. As a result, its exports cost less, making it more competitive on the global market. For more, see Currency Wars . Purchasing power parity solves the problem of comparing countries with different standards of living. It recalculates the value of a country's goods and services as if they were being sold at U.S. prices.

Under PPP, a Chinese Big Mac costs $5.04, the same as it does in the United States. As a result, China's GDP under PPP is $19.39 trillion. That makes it the world's largest economy , ahead of the European Union and the United States. That's why the CIA provides GDP estimates on both an official exchange rate and a purchasing power parity basis. Without purchasing power parity, China's GDP per capita would only be around $6,475. That's lower than the standard of living in Ukraine, Algeria or Kosovo. With PPP, each of the 1.3 trillion people receives (on average) the benefit of $14,100 in economic production. That's better, but still only on the level of Libya and worse than Iraq. It's far less than the U.S. GDP per capita of $55,800. That's because the United States divides its GDP among only 319 million people. (Source: CIA Factbook ) Although this doesn't happen often, PPP is also used to set the exchange rate for new countries . It is used to forecast future real exchange rates. Continue Reading What is the Big Mac Index?

What is the Big Mac Index? Search the site What is the Big Mac Index? McDonald's as a Purchasing Power Parity Index By Justin Kuepper Updated June 22, 2016 The Big Mac Index is an index created by The Economist based on the theory of purchasing power parity (PPP). Over the long-term, the PPP theory states that currency exchange rates should equal the price of a basket of goods and services in different countries. And, what better basket of goods than McDonald's Big Mac - or at least its equivalent - in various countries? In theory, the price of a Big Mac reflects a number of local economic factors, ranging from the cost of the ingredients to the cost of local production and advertising. The resulting PPP metric is therefore considered by many economists to be a reasonable measurement of real world purchasing power. But investors should remember that there are some exceptions to the rule. In this article, we will take a look at how the Big Mac Index works, some drawbacks to consider, and how investors and economists can use it to draw actionable conclusions.

How the Big Mac Index Works The Big Mac Index is calculated by dividing the price of a Big Mac in one country by the price of a Big Mac in another country in their respective local currencies. The resulting value is then compared to the official exchange rate between the two currencies to determine if either currency is undervalued or overvalued according to the PPP theory. For example, suppose that a Big Mac in the U.S. costs one U.S. dollar and one in the eurozone costs two euros. The Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one, which could then be compared to the EUR/USD exchange rate. If the exchange rate was 1.5, investors could predict that the euro was undervalued by 0.5 euros per U.S. dollar. There are also many variants of the Big Mac Index that may be useful for investors. For instance, UBS Wealth Management expanded the index to include the number of hours that an average worker must work to earn enough to buy a Big Mac. Other groups created separate indexes for everything from Apple iPods to Starbucks coffees to Ikea Billy bookshelves.

The Consumer Price Index - a key measure of inflation - seeks to include all kinds of goods, but many of these economists believe that certain goods could provide a more accurate indicator. Of course, this is also the biggest downside associated with the Big Mac Index - it only includes a single item and lacks of the diversification seen in other economic indicators. Using the Big Mac Index Investors in the United States may not see much need for the Big Mac Index, since there are already a number of reputable price indexes available, such as the Consumer Price Index (CPI). But the index becomes useful in other countries where reliable indexes aren't available, such as those that manipulate government statistics or those that don't publish official data. For example, many economists believed that Argentina had been modifying its official consumer price data to understate its true rate of inflation between 2010 and 2012. So, The Economist used its Big Mac Index to find that the average annual rate of burger inflation was 19% compared to the country's official 10% rate of inflation in January of 2011. Investors can use data from the Big Mac Index in many different ways.

For instance, they can use the values to determine if a currency is overvalued or undervalued relative to others and trade based on that data in the foreign exchange market . Similarly, investors can measure changes in values over time to determine rates of inflation and compare that to official records. Key Takeaway Points The Big Mac Index is an index created by The Economist based on the theory of purchasing power parity (PPP). The Big Mac Index is calculated by dividing the price of a Big Mac in one country by the price of a Big Mac in another country in their respective local currencies. Investors can use data from the Big Mac Index in many different ways, ranging from determining rates of inflation to comparing currency valuations. Continue Reading Purchasing Power Parity: Weights Matter - Back to Basics: Finance & Development Purchasing Power Parity: Weights Matter Finance & Development The rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country Index this (photo: Alexander Becher/dpa/Corbis) How fast is the global economy growing? Is China contributing more to global growth than the United States? Where is the average person better off?

These types of questions are of great interest to economists and others, and at first blush it appears reasonable to assume that each has a clear-cut answer. But, as with many things in economics, the reality is different. To answer the questions, one must compare the value of the output from different countries. But each country reports its data in its own currency. That means that to compare the data, each country’s statistics must be converted into a common currency. However, there are several ways to do that conversion and each can give a markedly different answer. Two different yardsticks International financial institutions produce a wide range of regional and global statistics. The IMF, one of these institutions, publishes many of its statistics—such as the growth of real gross domestic product (GDP), inflation, and current account balances—twice a year in its World Economic Outlook (WEO). These statistics combine, or aggregate, the results from many countries into an average. The importance, or weight, of an individual country’s data in the overall result depends on the size of its economy relative to the others being compared. To derive these weights, one converts the GDP of a country in terms of its national currency into a common currency (in practice, the U.S. dollar).

One of the two main methods of conversion uses market exchange rates—the rate prevailing in the foreign exchange market (using either the rate at the end of the period or an average over the period). The other approach uses the purchasing power parity (PPP) exchange rate—the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. To understand PPP, let’s take a commonly used example, the price of a hamburger. If a hamburger is selling in London for £2 and in New York for $4, this would imply a PPP exchange rate of 1 pound to 2 U.S. dollars. This PPP exchange rate may well be different from that prevailing in financial markets (so that the actual dollar cost of a hamburger in London may be either more or less than the $4 it sells for in New York). This type of cross-country comparison is the basis for the well-known “Big Mac” index, which is published by the Economist magazine and calculates PPP exchange rates based on the McDonald’s sandwich that sells in nearly identical form in many countries around the world. Of course, any meaningful comparison of prices across countries must consider a wide range of goods and services.

This is not an easy task, because of the amount of data that must be collected and the complexities in the comparison process. To facilitate price comparisons across countries, the International Comparisons Program (ICP) was established by the United Nations and the University of Pennsylvania in 1968. PPPs generated by the ICP are based on a global survey of prices. For the 2003–06 round, each of the participating countries (about 147) provided national average prices for 1,000 closely specified products. PPP versus market rates So which method is better? The appropriate way to aggregate economic data across countries depends on the issue being considered. Market exchange rates are the logical choice when financial flows are involved. For example, the current account balance—which measures the funds coming into and going out of a country—represents a flow of financial resources across countries. It is appropriate to use the market exchange rate to convert these flows into dollars when aggregating across regions or calculating the global current account discrepancy. But for other variables, the decision is less clear cut. Take real GDP growth. International organizations use different approaches.

The World Bank uses market-based rates to determine the weights in its regional and global aggregations of real GDP, whereas the IMF and the Organization for Economic Cooperation and Development use weights based on PPP rates (although the IMF also publishes a global growth aggregate based on market rates in the WEO). Each methodology has its advantages and disadvantages. Advantages of PPP: A main one is that PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile, and using them could produce quite large swings in aggregate measures of growth even when growth rates in individual countries are stable. Another drawback of market-based rates is that they are relevant only for internationally traded goods. Nontraded goods and services tend to be cheaper in low-income than in high-income countries. A haircut in New York is more expensive than in Lima; the price of a taxi ride of the same distance is higher in Paris than in Tunis; and a ticket to a cricket game costs more in London than in Lahore. Indeed, because wages tend to be lower in poorer countries, and services are often relatively labor intensive, the price of a haircut in Lima is likely to be cheaper than in New York even when the cost of making tradable goods, such as machinery, is the same in both countries.

Any analysis that fails to take into account these differences in the prices of nontraded goods across countries will underestimate the purchasing power of consumers in emerging market and developing countries and, consequently, their overall welfare. For this reason, PPP is generally regarded as a better measure of overall well-being. Drawbacks of PPP: The biggest one is that PPP is harder to measure than market-based rates. The ICP is a huge statistical undertaking, and new price comparisons are available only at infrequent intervals. Methodological questions have also been raised about earlier surveys. Between survey dates, the PPP rates must be estimated, which can introduce inaccuracies into the measurement. Also, the ICP does not cover all countries, which means that data for missing countries must be estimated. Does it make a difference? It depends. There is a large gap between market- and PPP-based rates in emerging market and developing countries, for most of which the ratio of the market and PPP U.S. dollar exchange rate is between 2 and 4. But for advanced economies, the market and PPP rates tend to be much closer. As a result, developing countries get a much higher weight in aggregations that use PPP exchange rates than they do using market exchange rates.

The weights of China and India in the world economy are far greater using PPP exchange rates than market-based weights. Thus, the choice of weights makes a big difference in calculations of global growth, but little difference to estimates of aggregate growth in advanced economies. The per capita income gap between the richest and poorest countries is modestly reduced under PPP exchange rates (although it remains exceptionally large), and some countries jump up or down the income scale depending on the exchange rate conversion used. Tim Callen is an Assistant Director in the IMF’s External Relations Department. Updated: March 28, 2012 Purchasing Power Parity Purchasing Power Parity This material was originally created for Starting Point: Teaching Economics and is replicated here as part of the SERC Pedagogic Service. Summary In this case, students learn how, over a long period of time, the nominal value of a currency is related to the ratio of prices at home and abroad. They will search for a nominal exchange rate (e.g. the Japanese yen / U.S. dollar exchange rate), the consumer price levels in the domestic (the U.S. in this example) and in the foreign country (Japan in this example) and compute the ratio between the price levels.

Students will plot this ratio as an approximation of the purchasing power parity (PPP) and identify periods when it does, and does not, inform the evolution of nominal exchange rates. Through peer instruction, students will address each of the following issues: 1. Why does the purchasing power parity (PPP) increase or decrease over time? 2. When does the purchasing power parity (PPP) inform the value of a currency better: in the short run or in the long run? 3. What factors, besides price levels, influence the value of a currency? Learning Goals After the completion of this module students will be able to: 1. Use FRED graphs to perform data manipulations. 2. Use FRED graphs to perform a visual data comparison 3. Test how the purchasing power parity theory fits the actual data. 4. Understand the difference between the short-run and the long-run. Context for Use Ideally this module should be directed to an international or financial economics class; if the course syllabus has room for it, the data plotting can be used in an economics principles course as well. It can be used as an applied exercise included in a large lecture or student groups can be assigned to replicate it outside of class as a basis for a short assignment.

Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on the underlying assumptions of the purchasing power parity principle and on what factors may undermine it. Note that a more advanced treatment of this topic may compute the purchasing power parity both in absolute and in relative terms, experiment by changing the base period for the price indexes, and explore different data frequencies (e.g. quarterly, semiannual, or annual). These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct. Prerequisite skills: Graph literacy Prerequisite concepts: Nominal exchange rates; Law of One Price; Consumer price index Description and Teaching Materials Within a lecture discussing long-term determinants of exchange rates, an instructor will use this module to help students understand the computation of the purchasing power parity and to guide a discussion of its applicability. (Step 1) The instructor will first present a graph of a nominal exchange rate (Category: Money, Banking & Finance > Exchange Rates > By Country > [Select one]) For example, Japan (DEXJPUS).

The instructor should point out that foreign exchange is traded on a daily (five business days a week) basis and that exchange rates can be plotted with a high level of frequency. This fact will become relevant when introducing the price indexes. The instructor can ask students to identify periods when the exchange rate is increasing or decreasing in order to practice the concept of currency appreciation and depreciation. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the exchange rate. (Step 2) Starting from scratch, the instructor should then present the graphs for the price levels at home and abroad. Both consumer and producer price indexes are available for many countries. In this example we will use the consumer price index (Category: International Data > Indicators > Prices > Consumer Price Index). Make sure to first select the U.S. (CPIAUCSL) and then Add Data Series to New Line in the graph the series for the Japanese consumer price index (JPNCPIALLMINMEI). The instructor should point out that the price indexes are computed once a month, much less frequently than the foreign exchange rate. Notes: - The instructor should Copy to All Lines the shortest data range (usually for the foreign country) to facilitate the interpretation of the graph.

- The base period should be the same for both countries: Units > Index (Scale equal to 100 for chosen period) > (the international series use 2005 as the base year) Students will find that the cost of living at home and abroad is different both in levels and in rates of growth. Recalling the concept of the Law of One Price the instructor could check the student understanding of this concept by asking for the expected direction of change of the exchange rate. (Step 3) The instructor will combine the exchange rate and price information in one graph. First, we compute the purchasing power parity between the two currencies. Starting with the graph of the price levels described above, the instructor will Remove Line 2 (the price level abroad) and then Add Data Series to Line 1 (the price level abroad) in order to Create Your Own Data Transformation: b/a (price level abroad / price level in the U.S.) Note: The definition of the exchange rate determines how the purchasing power parity is computed. The FRED database reports exchange rates as the number of units of foreign currency per US dollar. Thus, the purchasing power parity must be computed as price level abroad over the price level in the U.S.

A class discussion question could be how to compute the purchasing power parity when the exchange rate is reported as the number of U.S. dollars per unit of foreign currency. (Step 4) Finally, the instructor will add to the graph above the plot of the exchange rate series: Add Data Series to New Line, selecting Scale > Right. The following is a list of questions that could be asked: Are the purchasing power parity and the nominal interest rate ever/frequently identical? Should we expect them to be identical? Which series is more volatile, the purchasing power parity or the nominal interest rate? What could explain the difference in volatility? Are there years when the purchasing power parity theory points to a currency appreciation (depreciation) while the actual nominal interest rate moves in the opposite direction? What could explain this divergence? When does the purchasing power parity theory work best at explaining the evolution of the nominal exchange rate: in the short run or in the long run? Further sophistication: Use the producer price index instead of the consumer price index for the computation of the purchasing power parity and compare the plots. Change the frequency of the nominal exchange rate data from daily to monthly, quarterly, semiannual... and compare the plots.

Teaching Notes and Tips Be sure to present the argument about how the Law of One Price should make the nominal exchange rate equal to the ratio of prices at home and abroad. A commonly referenced example on this topic is the Big Mac Index. The Economist computes this index annually and has created an interactive web page: An instructor may want to explore the fact that the computation of the purchasing power parity is influenced by the choice of prices, or price indexes, one employs. Furthermore, even when employing identically named price indexes across countries the composition of the basket of goods and services changes from country to country. The Division of International Labor Comparisons of the Bureau of Labor Statistics publishes a report on international indexes of consumer prices: From this activity to the computation of the real exchange rate only a small step is needed. The following resource should help the instructor make that connection. It would be advisable not to try and discuss the purchasing power parity theory and real exchange rates during the same class period. The Back to Basics series by the International Monetary Fund has an issue entitled "Why Real Exchange Rates": Assessment The recommended method for assessment for an international or financial economics class would be to have students write up a short memo where they test the applicability of the purchasing power parity theory to the actual data.

This should be a take-home assignment. References and Resources 1. The Big Mac Index as an example of the Law of One Price: 2. International comparison of price indexes: 3. The International Monetary Fund basic introduction to the real exchange rate 4. NBER paper: "A Century of Purchasing-Power Parity" by Alan Taylor (2000): None found in this page Files Last Modified: August 21, 2013 Short URL: What Is Purchasing Power Parity? (PPP) | Investopedia What Is Purchasing Power Parity? (PPP) By Investopedia | November 2, 2016 — 12:01 PM EDT Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time. One popular metric is purchasing power parity (PPP) . Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach. According to this concept, two currencies are in equilibrium or at par when a market basket of goods (taking into account the exchange rate) is priced the same in both countries.

This is how the relative version of PPP is calculated: Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2 To make a comparison of prices across countries that holds any type of meaning, a wide range of goods and services must be considered. The amount of data that must be collected, and the complexity of drawing comparisons makes this process difficult. To facilitate this, the International Comparisons Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations . Purchasing power parities generated by the ICP are based on a worldwide price survey that compares the prices of hundreds of various goods. This data, in turn, helps international macroeconomists come up with estimates of global productivity and growth. Every three years, the World Bank constructs and releases a report that compares various countries in terms of PPP and U.S. dollars. Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use weights based on PPP metrics to make predictions and recommend economic policy.

These actions often impact financial markets in the short run. Some forex traders also use PPP to find potentially overvalued or undervalued currencies. Investors who hold stock or bonds of foreign companies may survey PPP figures to predict the impact of exchange-rate fluctuations on a country's economy. PPP: The Alternative to Market Exchange Rates Using PPPs is the alternative to using market exchange rates. The actual purchasing power of any currency is the quantity of that currency needed to buy a specified unit of a good or a basket of common goods and services. PPP is determined in each country based on its relative cost of living and inflation rates. Purchasing power plus parity ultimately means equalizing the purchasing power of two differing currencies by accounting for differences in inflation rates and cost of living. The Big Max Index: An Example of PPP As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's Corp.’s ( MCD ) Big Mac burger in many countries since 1986.The highly publicized Big Mac Index is used to measure the purchasing power parity (PPP) between nations, using the price of a Big Mac as the benchmark .

The Big Mac index suggests that, in theory, changes in exchange rates between currencies should affect the price that consumers pay for a Big Mac in a particular nation, replacing the "basket" with the famous hamburger. For example, if the price of a Big Mac is $4.00 in the U.S. as compared to 2.5 pounds sterling in Britain, we would expect that the exchange rate would be 1.60 (4/2.5 = 1.60). If the exchange rate of dollars to pounds is any greater, the Big Mac Index would state that the pound was overvalued, any lower and it would be under-valued. That said, the index has its flaws. First, the Big Mac's price is decided by McDonald's Corp. and can significantly affect the Big Mac index. Also, the Big Mac differs across the world in size, ingredients, and availability. That being said, the index is meant to be light-hearted and is a great example of PPP that is used by many schools and universities to teach students about PPP. What is the Difference Between GDP and GDP Accounting for PPP? In contemporary macroeconomics, GDP refers to the total monetary value of the goods and services produced within one country.

Nominal GDP calculates the monetary value in current, absolute terms. Real GDP takes the nominal GDP and adjusts it for inflation. Further, some accounts of GDP are adjusted for relative purchasing power parity or PPP. This adjustment is based on an attempt to convert nominal GDP into a number more easily comparable between countries with different currencies. GDP with PPP One way to think of what GDP with PPP represents is to imagine the total collective purchasing power of Japan if it were used to make the same purchases in U.S. markets. This only works after all yen are exchanged for dollars, otherwise, the comparison does not make sense. The net effect is to describe how many dollars it takes to buy $1 worth of goods in Japan as opposed to in the U.S. The following micro-example can illustrate that point. Suppose it costs $10 to buy a shirt in the U.S. It costs €8.00 to buy the same shirt in Germany. To make an apples-to-apples comparison, the €8.00 in Germany needs to be converted into U.S. dollars . If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would be 15/10, or 1.5.

For every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany. Which Nations Have the Greatest Purchasing Power? Gross domestic product (GDP) is the total dollar value of all goods and services produced by a country in a given year. It is one of the primary indicators used to evaluate a country's economy and can be calculated in market exchange terms and in purchasing power parity (PPP) terms. A country's GDP at PPP takes into consideration the relative costs of local goods and services produced in a country valued at prices of the United States. It factors in exchange rates and the inflation rates of each country. Further, GDP at PPP reflects the purchasing power of a citizen in one country to a citizen of another. For example, a pair of shoes may cost less in one country than another, so purchasing power parity is needed for fairness in the calculation. The five nations with the highest GDP in market exchange terms are the U.S., China, India, Japan, and Germany. This comparison changes when PPP is used. According to 2014 data from the International Monetary Fund (IMF), China has overtaken the U.S.

as the world's largest economy based on purchasing power with just over 16.5% of the global GDP. The U.S. comes in second with 16.5%. India, Japan, and Germany follow with 6.8%, 4.5%, and 3.4% respectively. The Downfalls of PPP: Short-Term Vs. Long-Term Parity Empirical evidence has shown that for many goods and baskets of goods , PPP is not observed in the short-term , and there is uncertainty over whether it applies in the long-term. In “Burgernomics,” (2003) a prominent paper that explores the Big Mac Index and PPP, authors Michael Pakko and Patricia Pollard cite several confounding factors as to why PPP theory does not line up with reality. The reasons for this differentiation include: Transport Costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will consequently sell at a relatively higher price than the same goods available from local sources. Taxes: When government sales taxes , such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country.

Government Intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing the price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower. Governments that restrict exports will see a good's price rise in importing countries facing a shortage , and fall in exporting countries where its supply is increasing. Non-Traded Services: The Big Mac's price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of the storefront, and other expenses such as insurance, heating and the cost of labor . According to PPP, in countries where non-traded service costs are relatively high, goods will be relatively expensive, causing such countries' currencies to be overvalued relative to currencies in countries with low costs of non-traded services. Market Competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices. The company's sought-after brand might allow it to sell at a premium price as well.

Conversely, it might take years of offering goods at a reduced price to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome. Inflation: The rate at which the price of goods (or baskets of goods) is changing in countries, the inflation rate, can indicate the value of those countries' currencies. Such relative PPP overcomes the need for goods to be the same when testing absolute PPP discussed above. Trending

Question: What international consumer item does the "Economist" use to compare purchasing power between countries?
Answer: Big Mac