Purchasing power parity (PPP) is an economic indicator used to compare the actual value of currencies across different countries or regions. PPP is calculated in international dollars. PPP is based on the US dollar, with the purchasing power of 1 US dollar in the United States serving as the reference base. Therefore, the purchasing power of 1 international dollar in a particular country is equal to the purchasing power of 1 US dollar in the United States. As a result, in many cases, PPP is directly expressed in USD.
Applications of Purchasing Power Parity
Price Level Differences: Different countries or regions have varying living costs and price levels. PPP aims to eliminate these differences, enabling more accurate economic comparisons.
Theoretical Exchange Rate: The exchange rate calculated by PPP often differs from the market exchange rate. The market exchange rate is influenced by various factors, while the PPP exchange rate focuses more on the actual purchasing power of a currency.
Comparability: PPP makes economic indicators (such as GDP) comparable across different countries or regions. By converting these indicators into the same currency unit (usually the US dollar), it is possible to more accurately compare the economic size and living standards of different countries or regions.
Example: If the Mexican peso depreciates by half against the US dollar, the GDP in US dollars will also be halved. However, this does not mean that Mexicans have become poorer. If the income and price levels in pesos remain unchanged, and the import and export of goods are not significant to the living standards of Mexicans, the currency depreciation will not lead to a deterioration in the quality of life for Mexicans. Using PPP can avoid this problem.
Disadvantages of PPP
Ignoring Non-Tradable Goods and Services: PPP focuses primarily on the prices of tradable goods and services, but ignores price differences in non-tradable goods (such as housing, healthcare, and education). The prices of these non-tradable goods can vary significantly across different countries or regions, affecting the accuracy of PPP.
Trade Barriers and Transportation Costs: PPP assumes that goods and services can move freely across borders, but in reality, there are trade barriers such as tariffs and quotas, as well as transportation costs and logistical obstacles. These factors can affect the actual prices of goods and services, leading to deviations between PPP and market exchange rates.
Capital Flows and Exchange Rate Fluctuations: PPP focuses mainly on the equilibrium of goods and services markets, but ignores the impact of capital flows on exchange rates. In the short term, capital flows can lead to significant exchange rate fluctuations, deviating from the levels predicted by PPP.
Imperfectly Competitive Markets: PPP assumes that markets are perfectly competitive, but in reality, there are imperfectly competitive market structures such as monopolies and oligopolies. These market structures can lead to price distortions, affecting the accuracy of PPP.
While purchasing power parity theory is a useful economic tool, its limitations should be carefully considered in practical applications. When conducting international comparisons and policy analysis, it should be used in conjunction with other economic indicators and factors for a comprehensive assessment.
