Purchasing power parity
In economics, purchasing power parity (PPP) is a theoretical exchange rate derived from the perceived parity of purchasing power of a currency in relation to another currency. In contrast to the "real" exchange rate that the currencies are traded for in the official market (as opposed to the black market). The PPP exchange rate is calculated from the relative value of a currency based on the amount of a "basket" of goods the currency will buy in their nation of usage. Typically, the prices of many goods will be considered, and weighted according to their importance in the economy. The most common PPP exchange rate comes from comparing goods in a GDP reporting area with equivalent goods in the United States and through that come up with a PPP US dollar exchange rate. When GDP numbers from reporting regions are converted through this PPP exchange rate it's perceived to be a better comparison of standard of living. For a current list see the IMF reporting areas reported Gross Domestic Product number and the PPP US dollar exchange rate used to convert it (2003): http://www.imf.org/external/pubs/ft/weo/2004/02/data/dbcoutm.cfm?SD=2003&ED=2003&R1=1&R2=1&CS=3&SS=2&OS=C&DD=0&OUT=1&C=914-446-612-666-614-672-311-946-213-137-911-962-193-674-122-676-912-548-313-556-419-678-513-181-316-682-913-684-124-273-339-921-638-948-514-686-218-688-963-518-616-728-223-558-516-138-918-353-748-196-618-278-522-692-622-694-156-142-624-449-626-564-628-283-228-853-924-288-233-293-632-566-636-964-634-182-238-453-662-968-960-922-423-714-935-862-128-716-611-456-321-722-243-965-248-718-469-724-253-576-642-936-643-961-939-813-644-199-819-184-172-524-132-361-646-362-648-364-915-732-134-366-652-734-174-144-328-146-258-463-656-528-654-923-336-738-263-578-268-537-532-742-944-866-176-369-534-744-536-186-429-925-178-746-436-926-136-466-343-112-158-111-439-298-916-927-664-846-826-299-542-582-443-474-917-754-544-698-941&S=NGDP-PPPEX&CMP=0&x=61&y=16.
The PPP method considers a bundle of goods, then calculates the price of this bundle in each country (using the country's local currency.) To calculate the exchange rate between two currencies, one takes the ratio of the prices.
A simple example of a measure of absolute PPP is the Big Mac index popularised by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. If a Big Mac costs USD$4 in the US and GBP£3 in Britain, the PPP exchange rate would be £3 for $4.
Relative PPP is concerned with change of price levels over different periods, also known as inflation rate. The equation looks like , whereby is the spot_rate and is the price in period t (Foreign values are marked by an asterisk). The change in the exchange rate is determined by price level changes in both countries. For example, if prices in the USA rise by 3% and prices in the European union rise by 1% the USD has to depreciate by 2% compared to the EUR (or alternatively the EUR will appreciate by 2%).
A common measure of the standard of living is the per capita Gross Domestic Product, which is calculated by dividing the GDP of a country by its population. In order to compare the standard of living in two nations, one first needs to express these numbers in the same currency. Using actual exchange rates when making these comparisons can give a very misleading picture of living standards. The PPP method is used to as an alternative.
For example, if the value of the Mexican peso falls by half compared to the US dollar, the Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are any poorer; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.
Difficulties with PPP comparisons
While using PPP exchange rates for comparison is an improvement over using actual exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another. The PPP method does not account for this.
A PPP exchange rate varies depending on the choice of goods used for the index. Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of a bundle. PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another.
Even if a good PPP is used, GDP per capita is still a measure of the economic output of the whole economy, not a direct measure of the mean or median person's quality of life. Other factors such as the quality of homes and schools, access to public services, the extent of pollution, and strength of consumer protection laws are hard to quantify and generally not fully reflected in the GDP. Thus, even a PPP-adjusted measure of GDP per capita must be used with caution, as it is only one component of quality of life.
For example, in 2002, the GDP per capita for Japan was about US$40,000 and the PPP was estimated as $27,000, while in the US, GDP per capita was about $36,400 and the PPP was $35,400 (in reality, the PPP and Nominal numbers are per definition the same in the local currency of the GDP number for any particular time period). The US has higher crime rates and a greater extent of poverty and slums than Japan, while Japan has much less physical space per person and arguably less individual freedom. Ultimately, the quality of life will depend on subjective judgement and individual preferences.
Per capita income also does not take into account inequalities in wealth distribution.
The GDP number for all reporting areas are one number in the reporting areas local currency. Therefore, in the local currency the PPP and market (or government) exchange rate is always 1.0 to its own currency, so the PPP and market exchange rate GDP number is always per definition the same for any duration of time, anytime, in that areas currency. The only time the PPP exhange rate and the market exhange rate can differ is when the GDP number is converted into another currency.
Only because of different base numbers (because of for example "current" or "constant" prices, or an annualized or averaged number) are the USD to USD PPP exchange rate not 1.0, see the IMF data here: http://www.imf.org/external/pubs/ft/weo/2004/02/data/dbcoutm.cfm?SD=1980&ED=2005&R1=1&R2=1&CS=3&SS=2&OS=C&DD=0&OUT=1&C=111&S=NGDP_R-NGDP-NGDPD-NGDPRPC-NGDPPC-NGDPDPC-PPPWGT-PPPEX-PPPPC&CMP=0&x=59&y=15. The PPP exhange rate is 1.023 from 1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's the base year for the "constant" (inflation adjusted) currency.
During 2003 the US Dollar bought on average about 550 CFA franc. Because of a difference in the perceived "purchasing power parity" within some of the regions using the CFA franc, their purchasing power parity exchange rate differed like this (lower is stronger parity): Cameroon 240, Central African Republic 166, Chad 172, Republic of the Congo 677, Equatorial Guinea 114, Gabon 413, Benin 273, Burkina Faso 167. (http://www.imf.org/external/pubs/ft/weo/2004/02/data/dbcoutm.cfm?SD=2003&ED=2003&R1=1&R2=1&CS=3&SS=2&OS=C&DD=0&OUT=1&C=914-446-612-666-614-672-311-946-213-137-911-962-193-674-122-676-912-548-313-556-419-678-513-181-316-682-913-684-124-273-339-921-638-948-514-686-218-688-963-518-616-728-223-558-516-138-918-353-748-196-618-278-522-692-622-694-156-142-624-449-626-564-628-283-228-853-924-288-233-293-632-566-636-964-634-182-238-453-662-968-960-922-423-714-935-862-128-716-611-456-321-722-243-965-248-718-469-724-253-576-642-936-643-961-939-813-644-199-819-184-172-524-132-361-646-362-648-364-915-732-134-366-652-734-174-144-328-146-258-463-656-528-654-923-336-738-263-578-268-537-532-742-944-866-176-369-534-744-536-186-429-925-178-746-436-926-136-466-343-112-158-111-439-298-916-927-664-846-826-299-542-582-443-474-917-754-544-698-941&S=PPPEX&CMP=0&x=48&y=13)
The CIA uses the purchase power parity method in its calculations of Gross National Product http://www.cia.gov/cia/publications/factbook/fields/2001.html. By this measure with its grossly undervalued currency, the People's Republic of China has the second largest economy in the world, $6.449 trillion (2004 est.).
The CIA's GDP methodology
"In the Economy category, GDP dollar estimates for all countries are derived from purchasing power parity (PPP) calculations rather than from conversions at official currency exchange rates. The PPP method involves the use of standardized international dollar price weights, which are applied to the quantities of final goods and services produced in a given economy. The data derived from the PPP method provide the best available starting point for comparisons of economic strength and well-being between countries. The division of a GDP estimate in domestic currency by the corresponding PPP estimate in dollars gives the PPP conversion rate. Whereas PPP estimates for OECD countries are quite reliable, PPP estimates for developing countries are often rough approximations. Most of the GDP estimates are based on extrapolation of PPP numbers published by the UN International Comparison Program (UNICP) and by Professors Robert Summers and Alan Heston of the University of Pennsylvania and their colleagues. In contrast, the currency exchange rate method involves a variety of international and domestic financial forces that often have little relation to domestic output. In developing countries with weak currencies the exchange rate estimate of GDP in dollars is typically one-fourth to one-half the PPP estimate. Furthermore, exchange rates may suddenly go up or down by 10% or more because of market forces or official fiat whereas real output has remained unchanged. On 12 January 1994, for example, the 14 countries of the African Financial Community (whose currencies are tied to the French franc) devalued their currencies by 50%. This move, of course, did not cut the real output of these countries by half. One important caution: the proportion of, say, defense expenditures as a percentage of GDP in local currency accounts may differ substantially from the proportion when GDP accounts are expressed in PPP terms, as, for example, when an observer tries to estimate the dollar level of Russian or Japanese military expenditures.
Note: the numbers for GDP and other economic data cannot be chained together from successive volumes of the Factbook because of changes in the US dollar measuring rod, revisions of data by statistical agencies, use of new or different sources of information, and changes in national statistical methods and practices." http://www.cia.gov/cia/publications/factbook/docs/notesanddefs.html
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