Purchase power parity

Purchase power parity (PPP) is a tool for measuring how much goods cost in different countries. If two goods are sold in two countries, it should have the same price when expressed in the same currency. In theory, this occurs when countries are producing the same goods and there is a free flow of goods with transportation costs subtracted off.

For example: Countries 1 and 2 produce oranges. Country 1 sells the oranges at $5/kg and it costs $2/kg to ship the oranges to country 2, country 2 wouldn't sell oranges for more than $7/kg (the total of the cost in country 1 and the transportation cost). This equivalence can help us determine how much each country's currency is worth.

Purchase Power Parity Equation

E_nom = $\frac{Pfor}{P}$

• P= Domestic Price Level
• P_for= Foreign Price Level
• E_nom= Nominal Exchange Rate

If the price of a good in currency A is the same as the price of the same good in currency B when it is converted to currency A then there is PPP between the two currencies.

For example, if we compare buying bread in Canada (CAN) and the United Kingdom (UK), if the currencies are in PPP the price should be the same when they are both expressed in $CAN:

If the nominal exchange rate between CAN and the UK is 0.50, and bread costs $4.00CAN and £2.00GBP then there is PPP because the price of bread is the same when both expressed in $CAN.

0.50 = $\frac{2.00GBP}{4.00CAN}$

$\frac{2.00GBP}{0.50}$= 4.00 CAN

If the price in GBP when expressed in CAN is not the same however, then PPP does not exist:

0.50 ≠ $\frac{2.60GBP}{4.00CAN}$

$\frac{2.60GBP}{0.50}$= 5.20 CAN

In Theory...

There are a number of reasons why the PPP theory does not hold (in the short term):

• Transportation costs
• Legal barriers
• Trade barriers
• Differences in the same goods

These factors interfere with the basic assumptions of the PPP theory in the short-term but there is some proof of an effective theory in the long-term. Referring to the previous bread example, if for some reason people in the UK don't usually eat bread, the bread will be more expensive as a result and the currencies to not be in PPP.
PPP is generally measured over a bundle of similar goods common in both countries. It does not make sense to put beef in a bundle when comparing countries such as Canada and India. This is because in Canada we eat a very large amount of beef per person but due to religious dietary restrictions, a large proportion of Indian people do not eat beef. Creating an appropriate bundle is essential in determining PPP between two countries.