Purchasing Power Parity Method

Since goods or services in each country are priced in their own currency, it is difficult to make a clear comparison of the price of a given good or service in two different countries.

If a handbag cost 5,000 Yen, an American shopper might think that it was outrageously expensive, unless she realized there were about 113 Yen in a dollar, and that it would really only cost her about $44. That would not, of course, tell her how expensive it was to a Japanese shopper, because that would depend many other factors internal to her country, such as wages, inflation, etc. If our Japanese shopper's wage was only 5,000 Yen a week, that handbag would indeed be very expensive.

Economists use Purchasing Power Parity (PPP) to measure how much a currency can buy relative to other currencies. It is a method primarily used to make comparisons of standards of living between different countries. For example, the GDP (Gross Domestic Product) of a country is measured in its local currency, therefore any comparison between two countries' economies requires converting each currency. However, using commercial foreign exchange rates is not very accurate, as they do not reflect price differences between the countries. PPP takes these variables into account.

The PPP method considers a bundle of goods, and then calculates the price of this bundle in each country, in each country's own currency. To calculate a true exchange rate between two currencies, one takes the ratio of the price of this bundle of goods. (A mixed "bundle" is used, to smooth out inherent price disparities between goods, reflecting that some products may be cheaper in one country due to supplies of raw materials and other factors.)  The simplest form of PPP theory is based on the "law of one price" that states that the same goods should sell for the same price in two separate markets as long as transportation costs or taxes are applied no differently in the two markets.

A less formal approach used by the international news magazine The Economist measures one very standard item sold in many countries to calculate the PPP of various currencies. This item is the Big Mac hamburger sold in McDonald's restaurants around the world. The Big Mac index (The Economist, June 11, 2005) lists the average price of a Big Mac in the U.S. as $3.06, in Argentina, (the equivalent of) $1.64, in China $1.27, in the Euro area $3.58, in Mexico, $2.58 and in Switzerland $5.05.  Based on the exchange rates at that time, this indicates that the Argentine peso is undervalued against the dollar by 46%, the Chinese yuan is undervalued by 59%, the Euro is overvalued against the dollar by 17%, the Mexican peso is undervalued by 16% and the Swiss franc is overvalued against the dollar by 65%.  Why are these currencies considered under or over-valued? In a perfect world, if a Big Mac cost $4 in the US and £3 in Britain, the exchange rate of the dollar versus the Pound should be £3 for $4, or 1.33 pounds for each dollar. It is not; it is more like to .57 pounds per dollar. The PPP exchange rate reflects the real value of one currency against another and any disparities would reflect an "overvaluation" or "undervaluation" of one currency for another.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.