Introduction

Purchasing Power Parity (PPP) is a key macroeconomic metric that provides a framework for comparing currency values and living costs across countries. It is grounded in the “Law of One Price,” which asserts that identical goods should cost the same in different countries when prices are converted into a common currency. This principle ensures equal purchasing power for the same products globally.

In practice, achieving this standard takes time and effort. To apply the “Law of One Price,” the economic output of different countries must be evaluated. However, since countries report economic data in their local currencies, this data must be converted into a common currency, typically the United States Dollar (USD), for meaningful comparison.

PPP offers valuable insights into price disparities and helps explain how exchange rates are determined. It serves as a critical tool for policymakers, investors, and economists, enabling them to assess economic conditions and make informed decisions on a global scale.

What is Purchasing Power Parity (PPP)?

Source: Investopedia

Understanding “Purchasing Power” is crucial for grasping the concept of Purchasing Power Parity (PPP), as the two are closely related and provide valuable insights into the relative value of currencies and the cost of living across different countries. Purchasing Power refers to the quantity of goods and services that can be bought with a specific amount of currency. It reflects how much value a currency holds in terms of purchasing goods. For instance, if you can buy more goods with the same amount of currency in one country compared to another, it indicates higher Purchasing Power in the former.

On the other hand, Purchasing Power Parity measures the cost of specific goods in different countries, allowing for comparisons of the relative Purchasing Power of currencies. PPP is based on the “Law of One Price,” which states that identical goods should have the same price in different countries when converted into a common currency. By analyzing the prices of specific goods and services across countries, PPP helps us understand how much a currency can actually buy in terms of real goods and services.

The History of Purchasing Power Parity

The idea of Purchasing Power Parity originated at the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel, a Swedish Economist, in 1976. He introduced it as a way to compare price levels across different countries, emphasizing that exchange rates should be adjusted to equalize the price of identical goods and services across different countries.

His theory gained prominence during the interwar period, serving as a tool used to analyze exchange rates during the post-World War I period. Also, it was used by Economists to understand how inflation affected and influenced the currency value of different countries.

In 1968, the United Nations and the University of Pennsylvania jointly established the International Comparison Program (ICP) to facilitate price comparison in different countries. The Purchasing Power Parity that was generated was based on global survey prices, from the last round that took place between 2003 and 2006, with a total of 147 countries participating, they provided a national average price summed up about 1,000 closely specified products.

How Does It Work?

Purchasing Power Parity is a commonly used metric since it has proven relatively stable over time. It is a concept used by economists to adjust a country’s GDP (Gross Domestic Product).

Previously, the alternative metric used before PPP was the nominal GDP metric, which takes the country’s exchange rate and converts it to the GDP value. However, there were outstanding limitations attached to this metric, which included;

• Volatile exchange rate
• Consideration of only tradable goods and services

This concept merely begins to address the complexity, as most non-tradable goods and services, which constitute the majority of factors influencing a currency’s value and a country’s standard of living, play a significant role. This is precisely why Purchasing Power Parity (PPP) was introduced.

Purchasing Power Parity serves as a tool for adjusting the GDP figure for price differences between countries and also creating a deeper understanding of how far money can be stretched in different countries. That explains why the minimum wage of different countries differs from that of other countries and why a certain amount of income could give you a better livelihood in one country than in another.

It also helps measure the inflation rate across countries, clearly pointing out countries with weaker Purchasing Power and those with stronger Purchasing Power. Although not inter-related, it is believed that PPP in conjunction with cryptocurrency will create a way for people to maintain their Purchasing Power, regardless of their currency’s value with the help of stablecoin.

Evaluation of the Big Mac Index

Source: Britannica

The Big Mac Index was introduced in 1986 by “The Economist” as an accessible and insightful way to illustrate the concept of Purchasing Power Parity (PPP) to a global audience. Using a single, standardized product—the McDonald’s Big Mac—the index provides a practical tool for comparing currency values across countries. The Big Mac was chosen because its recipe is consistent worldwide, making it an ideal representative of “the basket of goods” often used in economic analyses. As McDonald’s operates in over 100 countries, the Big Mac serves as a universal benchmark for price comparisons.

How the Big Mac Index Works

The Index compares the price of a Big Mac in various countries’ local currencies to its price in U.S. dollars, given McDonald’s status as a U.S.-based company and the dollar’s role as a global benchmark currency. Here’s how the process unfolds:

1. Data Collection: The price of a Big Mac is collected in the local currency at McDonald’s outlets worldwide.
2. Conversion to USD: Local prices are converted to U.S. dollars using the current exchange rate.
3. Implied PPP Calculation: The implied PPP is determined by dividing the local price of a Big Mac by its U.S. price.
4. Comparison: The implied PPP is compared to the actual exchange rate.

If a currency’s exchange rate indicates that the local price of a Big Mac is higher than the implied PPP, the currency is deemed overvalued. Conversely, the currency is considered undervalued if the local price is lower.

An Example: The British Pound (2023)

In August 2023, a Big Mac cost $5.58 in the U.S. and £4.19 in the U.K. The implied exchange rate was calculated as 0.75 (4.19 ÷ 5.58). Comparing this to the actual exchange rate of 0.79, the British pound was undervalued by 3.8% relative to the U.S. dollar. This undervaluation meant that U.S. goods were relatively more expensive for British consumers, while British goods appeared cheaper to U.S. buyers.

Later in the year, the undervaluation of the pound decreased to just 0.36%, reflecting a shift in currency dynamics.

A Reliable Indicator of Currency Valuation

The Big Mac Index has become a widely recognized tool for assessing currency valuation and understanding global economic conditions. By comparing the cost of a Big Mac across countries, the index highlights differences in PPP and provides insights into the relative strengths of national currencies. Despite its simplicity, the Big Mac Index remains a reliable and effective economic indicator in the global marketplace.

How Does Purchasing Power Parity Influence the Cryptocurrency Market?

Purchasing Power Parity (PPP) is an economic tool used to compare the relative value of currencies by examining the cost of a standard basket of goods across different countries. When applied to the cryptocurrency market, PPP can serve as a metric to promote equal access and fairness, ensuring that the valuation of cryptocurrencies remains consistent across regions despite varying economic conditions.

As a global asset, cryptocurrency is inherently exposed to valuation disparities driven by regional economic factors. PPP can help explain these price variations observed across exchanges in different countries. By harmonizing the relative value of currencies, PPP can also reduce barriers for individuals in regions with weaker purchasing power, thus fostering inclusivity and aligning with the principle of the “law of one price.” This would contribute to unifying the global standard of living and improving accessibility to the cryptocurrency market.

Implementing PPP in cryptocurrency could promote fairness in global participation, stabilizing fragile economies and mitigating market volatility. While cryptocurrency is intended to operate as a borderless and inclusive financial system, discrepancies in regional participation persist. By aligning cryptocurrency prices with PPP, the market could establish standardized pricing across regions, enhancing accessibility for users in economically disadvantaged areas.

However, while PPP offers numerous benefits to the cryptocurrency market, there are notable challenges and implications to consider:

Arbitrage Risks

Variations in PPP can result in price disparities for cryptocurrencies across different exchanges. Traders could exploit these differences through arbitrage, buying in regions with lower PPP and selling in higher PPP regions, potentially destabilizing the market.

Transaction Costs Vs. Local Purchasing Power

In regions with weaker purchasing power, residents may view cryptocurrency as a hedge against inflation or currency devaluation. However, high transaction fees relative to their local currency can pose significant barriers to participation. Aligning cryptocurrency prices and transaction costs with PPP could mitigate these challenges, ensuring a more inclusive and equitable crypto economy.

By addressing these implications, PPP could play a pivotal role in creating a more accessible and equitable global cryptocurrency market while minimizing the risks associated with regional economic disparities.

Understanding the Difference Between Market Exchange Rate and Purchasing Power Parity (PPP)

The distinction between the Market Exchange Rate and the PPP Rate is significant. Notably, the PPP Rate tends to be higher than the Market Exchange Rate due to fundamental differences in their calculation and application.

Market Exchange Rate

The Market Exchange Rate reflects the value of one currency relative to another based on current trading conditions. However, it is limited in scope because it primarily considers tradable goods and services while excluding non-tradable goods and services. This omission is critical, as non-tradable goods and services are often significantly cheaper in low-income countries than in high-income countries, skewing the exchange rate’s reflection of economic reality.

The Market Exchange Rate is also subject to volatility, influenced by external factors such as:

• Government intervention/unstable regulations
• Varying interest rates
• Speculative activities
• Trading dynamics
• Hedging strategies

These external forces contribute to fluctuations in the Market Exchange Rate, making it less stable over time.

Purchasing Power Parity (PPP)

In contrast, the PPP rate is regarded as a more accurate measure of currency value as it accounts for the relative cost of goods and services between countries. However, determining the PPP rate is complex due to factors such as:

• Variations in purchasing habits among populations
• Differences in the quality of goods and services
• Disparities in economic structures

Once calculated, the PPP rate is largely immune to external influences, making it more stable and consistent over time compared to the market exchange rate.

Why PPP Matters

When comparing the economic output of countries, PPP provides a more precise metric for evaluating GDP. Unlike the market exchange rate, which is often influenced by external market conditions, PPP offers a more reliable basis for cross-country economic comparisons, particularly when assessing living standards and economic productivity.

By addressing the limitations of market exchange rates, PPP emerges as an essential tool for achieving a deeper understanding of global economic dynamics.

Versions of Purchasing Power Parity

Source: YouTube channel–CA Nikhil Jobanputra

There are two main versions of Purchasing Power Parity;

1. The Absolute Purchasing Power Parity
2. The Relative Purchasing Power Parity

The Absolute Purchasing Power Parity

This version, also known as the “Law of One Price”, states that “the same product in different countries should be equal.” It assumes that exchange rates are fixed and based on the ratio of the price levels between two countries and shouldn’t be adjusted for inflation.

For example, the price of a pizza in the U.S. costs $3.80, and the same pizza costs €3.45 in Italy. According to the Law of One Price, the price should be the same; hence, the exchange rate should be determined by finding the ratio of both prices.

Exchange = $ ÷ € = Price$ ÷ Price€

Dividing the price of an item in one country by the price of the item in the other country:

$3.80 ÷ €3.45 = $1.10/€1

Therefore, the outcome is $1.10:€1.

The Relative Purchasing Power Parity

Source: Investopedia

This approach accounts for inflation, making consistent adjustments to incorporate its effects. It proposes that exchange rates will evolve over time to balance the purchasing power of different currencies. This is achieved by examining the correlation between fluctuations in exchange rates and changes in relative price ratios.

NB: The price level increases in the presence of inflation, and the exchange rate is determined by the difference in the national price levels between the two countries.

∆Exchange Rate $/€ = ∆•Price$ ÷ Price€

Assuming there’s 5% inflation in the U.S. and 0% inflation in Kosovo with an exchange rate of $1.10:€1, what would be the expected exchange rate?

We assumed a 5% inflation in the U.S., so we calculate the following to get the expected exchange rate:

1.10 × 1.05 = 1.155 $/€

Therefore, where there is inflation, the value of a currency depreciates, and vice versa.

Technical Structure of Purchasing Power Parity

This revolves around its foundation in economics and how it is used to determine exchange rates, measure inflation, and compare cross-country purchasing power.

Here’s a breakdown of the technical framework and mathematical formula for calculating purchasing power parity:

Law of One Price

P^f • E = P^l

E = P^f ÷ P^l

Where:

P^f is the price of goods in a foreign country

P^l is the price of goods in the local country

E is the exchange rate (local currency per unit of foreign currency)

Relative Purchasing Power Parity

E1/Et-1 = 1+πf/1+πl

∆E = πf - πl

Where:

Et is the exchange rate at time t

πf is the inflation rate in foreign countries

πl is the inflation rate in the local country

Index-Based Approach

Eppp = CPI of foreign country ÷ CPI of local country

Note: CPI stands for Consumer Price Index

Purchasing Power Parity combines theoretical principles and mathematical formulas to assess the value of currency and the influence of inflation.

Conclusion

Purchasing Power Parity, though not a perfect measuring tool, enables price comparison between countries with different currencies. It offers a lens through which the global economy can be viewed by many Economists, international organizations, foreign exchange traders, and investors. It helps them examine economic productivity and the value of investments. Lastly, it helps clarify complex economic relationships, fostering better trade policy and investment decision-making.