top of page
How Purchasing Power Parity (PPP) Is Used.
By: A SWEENEY | Feb 18th, 2021

What Is Purchasing Power Parity (PPP)?

A popular theory widely used by global institutions for the comparison of living cost, productivity and poverty between countries. Purchasing power parity is a theoretical exchange rate that would allow you to buy the same amount of goods and services in every country. For example: If a bottle of Coca Cola costs £1.20 in the UK but $1.70 in the United States, the PPP implied exchange rate would be $1.42. However, the real time market exchange rate could be trading higher or lower than this figure causing inefficiencies with the theory. 

PPP is broken down into two main concepts, 1) Absolute PPP 2) Relative PPP:

1) Absolute PPP is the theory is basic form, stating exchange rates between two countries should be equal to the ratio of the countries price levels. APPP states that exchange rates should adjust over time to return to the price of goods to equilibrium, assuming no other outside factors such as inflation, transport costs, government intervention and so on. 

2) Relative PPP (RPPP) follows on from APPP stating similar assumptions however RPPP acknowledges the relationship between inflation and exchange rates. It looks to equalise prices in the same manner as APPP however as prices change over time, inflation must be included to get a more accurate implied PPP.

PPP uses a basket of goods to compare price differentials in tradable and non-tradable sectors, allowing us to estimate more accurate exchange rate for making comparisons than using volatile market spot rate. The the traditional basket of goods used to determine exchange rates in PPP can be inconsistent as the quality, consumption and preference of goods and services varies drastically between nations.  

Anchor 1

Calculating PPP

The formula for calculating absolute PPP:

Screenshot 2021-03-15 at 21.09.10.png
Screenshot 2021-03-15 at 21.10.45.png
Anchor 2

Relative PPP (RRRP) states that exchange rates should offset the inflation differentials between countries, expressed as:

Screenshot 2021-03-15 at 21.34.10.png
Screenshot 2021-03-15 at 21.27.52.png

The Big Mac Index

In 1986, 'The Economist' magazine created the Big Mac Index, which became arguably the most famous test of the 'law of one price', measuring the purchasing power parity between countries using McDonalds Big Mac burger as a comparable benchmark. Although, the editors stated this index was to be used relatively loosely as it was not a precise method to determine exchange rate disequilibrium.

Anchor 3

In January 2021, the cost of a Big Mac in India was 190 Rupees, and $5.66 in the USA. Therefore the implied exchange rate would simply be 190/5.66 = 33.57. However, during this same period the actual exchange rate was 77.39, indicating that the Indian Rupee is 53.4% undervalued. 

Gross Domestic Produce and PPP

Due to the volatile nature of market exchange rates and the limited view on traded goods, nominal Gross Domestic Produce (GDP) is often adjusted for PPP in order to make for better comparisons between countries. The Big Mac Index also uses GDP adjusted figures to address the criticism surrounding the cheaper costs of labour and barriers to trade in certain countries, stating the cost of a Big Mac should be cheaper in countries where GDP per person is lower due to competitive disadvantages.

When using market exchange rates, calculations made for GDP tend to over estimate the cost of living in developing countries, otherwise known in economics as 'The Balassa Samuelson Effect'. As such, GDP tends to be compared internationally using the implied purchasing power parity exchange rate.

Anchor 4

PPP And The Financial Markets 

We have established that certain long run exchange rate theories are not solely used to predict future rates for trading or investment purposes as the empirical evidence gives little support. However,  as the Economic theory (RPPP) acknowledges the relationship between the change and exchange rates, it is not surprising that the literature on relative PPP in the long run shows some predictive ability and therefore could be a potential indicator for future movements although not a reliable singular tool to solely base decisions on; used in conjunction with further fundamental and technical analysis, RPPP can provide a long term investor/trader with useful information to use as an additional confluence. 

Anchor 5

Problems with Purchasing Power Parity

In reality the theory of equal prices is not so straight forward. There are limitations that the implied exchange rate cannot include, for example; transport costs, government interference, market competition structure and a globally adopted 'basket of goods' that is unlikely to be a fair comparison between nations. 

It is a fair assumption certain good are priced differently between countries as a result of anyone of these limitations; for instance, earphones in India might sell for a different price due to a competitive advantage over the same goods that are produced in China and then exported; external factors which impact the price of goods sold that are not related to PPP, thus creating limitations to the predictive ability of the theory. 

Anchor 6

The Bottom Line

While PPP is not a full proof method of predicting future exchange rates, the theory is a widely used metric for International comparison between countries whilst RPPP holds some predictive ability in the long run, it does not give investors sufficient information itself to make a conclusive decision on the future spot rate, therefore only provides a foundation to help build a long term directional bias. 

Anchor 7
bottom of page