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Purchasing Power Parity | Marginal Revolution University

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What Is Purchasing Power Parity (PPP)?

One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach.

According to this concept, two currencies are in equilibrium-known as the currencies being at par -when a basket of goods is priced the same in both countries, taking into account the exchange rates.

Key Takeaways

Calculating Purchasing Power Parity

Comparing Nations' Purchasing Power Parity

To make a meaningful comparison of prices across countries, a wide range of goods and services must be considered. However, this one-to-one comparison is difficult to achieve due to the sheer amount of data that must be collected and the complexity of the comparisons that must be drawn. To help facilitate this comparison, the University of Pennsylvania and the United Nations joined forces to establish the International Comparison Program (ICP) in 1968.

With this program, the PPPs generated by the ICP have a basis from a worldwide price survey that compares the prices of hundreds of various goods and services. The program helps international macroeconomists estimate global productivity and growth.

Every three years, the World Bank releases a report that compares the productivity and growth of 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. The recommended economic policies can have an immediate short-term impact on financial markets.

Also, some forex traders use PPP to find potentially overvalued or undervalued currencies. Investors who hold stock or bonds of foreign companies may use the survey's PPP figures to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment.

Pairing Purchasing Power Parity With Gross Domestic Product

In contemporary macroeconomics, gross domestic product (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 adjusts the nominal gross domestic product for inflation.

However, some accounting goes even further, adjusting GDP for the PPP value. This adjustment attempts to convert nominal GDP into a number more easily comparable between countries with different currencies.

To better understand how GDP paired with purchase power parity works, suppose it costs $10 to buy a shirt in the U.S., and it costs €8.00 to buy an identical shirt in Germany. To make an apples-to-apples comparison, we must first convert the €8.00 into U.S. dollars. If the exchange rate was such that the shirt in Germany costs $15.00, the PPP would, therefore, be 15/10, or 1.5.

In other words, for every $1.00 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro.

Drawbacks of Purchasing Power Parity

Since 1986, The Economist has playfully tracked the price of McDonald's Corp.'s (MCD) Big Mac hamburger across many countries. Their study results in the famed "Big Mac Index". In Burgernomics-a prominent 2003 paper that explores the Big Mac Index and PPP-authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.

Transport Costs

Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.

Tax Differences

Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.

Government Intervention

Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.

Non-Traded Services

The Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.

Market Competition

Goods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.

The Bottom Line

While it's not a perfect measurement metric, purchase power parity does allow for the possibility of comparing pricing between countries that have differing currencies.

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One popular macroeconomic analysis metric to compare economic productivity and standards of living between countries is purchasing power parity (PPP). PPP is an economic theory that compares different countries' currencies through a "basket of goods" approach.

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What Is the Big Mac Index?

The Big Mac index is a survey created by The Economist magazine in 1986 to measure purchasing power parity (PPP) between nations, using the price of a McDonald's Big Mac as the benchmark.

Purchasing power parity is an economic theory that states that exchange rates over time should move toward equality across national borders in the price charged for an identical basket of goods. In this case, the basket of goods is a Big Mac.

The Big Mac Index is also known as the Big Mac PPP or Burgernomics.

Key Takeaways

Understanding the Big Mac Index

According to PPP theory, any change in the exchange rate between nations should be reflected in a change in the price of a basket of goods.

One of the key insights of the Big Mac Index is that a basket of goods in one country can rarely be precisely duplicated in another country. For example, an American basket of groceries and a Japanese basket of groceries will likely contain very different products. A Big Mac, though, is always a Big Mac, allowing for slight local differences in ingredients.

The editors of The Economist stress that the index should not be taken too seriously. "Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible," an explainer on the site indicates.

Nevertheless, the Big Mac Index has become a global standard for price comparison. The Economist website shows the index in 54 countries, revealing that a Big Mac is relatively pricey in Switzerland, while people in Indonesia, India, and Taiwan are getting a bargain.

The Big Mac Index In Use

In August 2023, The Economist concluded that a Big Mac cost $5.58 in the U.S. and £4.19 in the U.K. The difference between the implied exchange rate of 0.75 and the actual exchange rate of 0.78 suggests the undervaluation.

As The Economist editors are quick to note, the Big Mac Index is not a perfect instrument.

As of 2023, McDonald's has outlets in 111 of 195 countries. Thus, this methodology cannot be used to analyze the PPP between the U.S. dollar and countries without a McDonald's, such as Bolivia or Iceland.

Nevertheless, economists consider the index to be a relatively accurate real-world indicator of local economic purchasing power since the pricing of a Big Mac, like most consumer goods, must take into account local costs of raw materials, labor, taxes, and business premises.

What Is the Big Mac Index?

The Big Mac index is a measurement sometimes used to discern the difference in purchasing power parity between two countries where BicMacs are sold. It began as somewhat of an economics joke, but it turned out to be fairly reliable.

Is the Big Mac Index a Good Indicator of Inflation?

The costs of raw materials, labor, transportation, taxes, and others are priced into Big Macs, so it is safe to say that the price of a Big Mac can reflect inflationary pressures.

What Is the Most Accurate Inflation Indicator?

The Consumer Price Index is considered the most accurate indication of inflation.

The Bottom Line

The Big Mac Index measures the cost of a Big Mac in different countries and indicates the difference in purchasing power parity between them. It has become accepted as a fairly reliable currency parity indicator for developed, developing, and non-developed countries (as long as Big Macs are sold there).

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What Is the Big Mac Index? Definition, What It Shows, and Example

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The Big Mac index was created by The Economist to measure purchasing power parity between nations, using the price of a Big Mac as the benchmark.