See also: Parity, PPP

The purchasing power parity (PPP) (one speaks about values measured in purchasing power parity ) is a method used in economy to establish a comparison between country of the Purchasing power of the national currencies, which a simple use of the Foreign exchange rate does not make it possible to do.

Explanations

The Purchasing power of a given quantity of money depends indeed on the Cost of living, i.e. general level of the Prix. The PPP makes it possible to measure how much a currency makes it possible to buy goods and services in each zone which one compares.

The goods and services used in the comparison form a “basket” Normalisé, whose contents can be subject to deposit (on this subject, to see) .

The Currency usually used as reference is the US Dollar, taken at a year given.

Not-unification of the prices

In a total Gone and unfié, without Cost of transport, the identical products have all the same price at the same moment T at all the places of this market.

In practice, the world is far from being a single European market. The costs of transport are not null, the regulations differ according to the countries, the Customs duties applied to the Importation S increase their selling prices.

In addition, the manufacturing costs strongly vary according to the countries: some Natural resources are more or less abundant, the climate varies, the Cost of labor strongly varies.

The prices are thus strongly different from one place to another.

Use

The Foreign exchange rate PPP are used above all in the international comparisons of Standard of living. The international comparison of GDP results in not taking into account the differences of existing Prix between the countries. The differences between the real Foreign exchange rates and foreign exchange rates PPP can be significant. For example, when the Yen, the Japanese currency, is overestimated, such as for example in 1999, the GDP per capita appears much higher than its American equivalent, whereas measured in PPP, it is actually much low.

This method makes it possible to be freed from three problems:

• the Foreign exchange rate of the currencies can know sudden and sharp variations without there being modification of the economic conditions. An international comparison of the short-term evolutions would be distorted by a use of the Foreign exchange rate of the market;
• the currencies of the poor countries are systematically underestimated on the Foreign exchange market because of their least Productivité (it is the Effet Balassa-Samuelson);
• Certains country administratively fixes the foreign exchange rate of their currency. That causes to distort the international statistics and comparisons. It was in particular the case of the countries of Europe of the East before 1989.

The use of the PPPS makes it possible to be freed from these three effects.

The PPP is sometimes used like a Indicateur of the undervaluation or overvaluation of a currency compared to another on the foreign exchange market. The exercise is hazardous, taking into account uncertainties inherent in this Measuring instrument.

Absolute PPP

The absolute PPP defines a rate of exchanges between two currencies. It is given by defining a basket of consumption in a country and by evaluating the price of a “similar” basket in another by the formula: $\{S\_t\}\; =\; \backslash \; frac\; \{P\_\; \{T\}\; ^*\}\; \{P\_\; \{T\}\}$, where $S\_t$ is the absolute PPP between the two countries, and $P\_t$ is the price at the period $t$ basket of reference in the domestic country. The foreign country is marked by an asterisk.

To take a quantified example, fictitious, if a basket of evaluated product with 1.000 $ with the the United States with average costs of 900 euros in France, then rate of exchange in PPP of the euro compared to the dollars will be of 0,90. This rate is calculated independently of the course of the euro in dollar on the foreign exchange market, which can strongly fluctuate.

Relative PPP

The relative PPP measures the variation of the PPP between two periods. It is expressed as follows:

$\backslash \; frac\; \{S\_t\}\; \{S\_\; \{T-1\}\}\; =\; \backslash \; frac\; \{P\_\; \{T\}\; ^*/P\_\; \{T-1\}\; ^*\}\; \{P\_\; \{T\}\; /P\_\; \{T-1\}\}$, where $S\_t$ is foreign exchange rate and $P\_t$ is the price at the period $t$ (the foreign country is marked by an asterisk).

A variation of the relative PPP makes it possible to highlight a variation of Inflation between two areas of the world.

Limits of the indicator

Several arguments limit the relevance and the use of the PPPS:

• the PPPS can vary in a very important way according to the choice of the basket of product. In this direction, it is subjected to the same limitations as the price indexes.

• the spending patterns and the choices are sometimes very variable between country. The products consumed by the populations depend on it and to build two equivalent baskets is a very subjective work.
• the differences in qualities for two products put in equivalence are difficult to evaluate.
• the prices can vary much inside the same country. The price of beer glass is much higher in a bar on the élysées fields than in a village in the Massif Central.
• the prices of the imported products depend on foreign exchange rate. A modification of foreign exchange rate to thus an influence on the PPP whereas this one is built to define an equivalence of exchange décorrélée of the foreign exchange market.

Indicators like the Index Big Mac, built initially by The Economist, or the index iPod, enough frustrate, are sometimes used at teaching ends.