Education Journalist | Study Abroad Lead
Purchasing power parity is also called PPP. It is an economic indicator that calculates the exchange rate and purchasing power of the currencies between different countries against each other. The purchasing power parity (PPP) uses a basket of goods approach. The biggest problem is that measuring PPP is more difficult than market-based interest rates. ICP is a huge statistical business and new price comparisons are rarely available.S = P1 / P2 is the formula of purchasing power parity.
| Table of Content |
Key terms: Purchasing Power Parity, Exchange Rates, Consumer, Countries, Economists, Economic Indicator, Power, Purchase
Also check: Potential Energy
What Is Purchasing Power Parity?
[Click Here for Sample Questions]
The purchasing power parity follows the law that for identical goods, there will be one price worldwide. The concept of purchasing power parity is that the countries' exchange rates should be at the same level/standard as each other. It helps the consumer to buy the same goods for the same price across the world. The purchasing power parity is an important concept of macroeconomics. Economists use it to determine economic productivity.
The formula of Purchasing Power Parity is represented as :
S = P1 / P2
Here,
S = Exchange rate of currencies
P1 = Cost of a good (currency first)
P2 = Cost of the identical good (currency second)
Purchasing Power Parity Formula
Also Read:
| Related Links | ||
|---|---|---|
| Marginal Cost Formula | Net Exports Formula | National Income Formula |
| Money Multiplier Formula | Marginal Product Formula | GDP Formula |
Applicability And Use Of Purchasing Power Parity Expression
[Click Here for Sample Questions]
Purchase of important power parity from the viewpoint of the global economy. PPP brings relevance and meaning from the economic point of view. For the exchange of products and services from various countries, PPP helps to maintain the exact costs for the same goods.
It allows economists to determine the standard price of living and living expenses of the nations. It also helps to compare production in different countries. Therefore, PPP is an economic indicator used to calculate exchange rates.
Also check: Semiconductor Diode
Step by Step Calculation of Purchasing Power Parity
[Click Here for Sample Questions]
Calculation of Purchasing Power Parity can be done using the Purchasing Power Parity (PPP) formula using the following steps:
- First, try to determine an easily available commodity in both countries.
- The next step is to find the cost of a commodity in the first country and the Cost in its currency. The price will show the standard of living of that country.
- Then analyze the Cost of the same commodity in the other country and cost in its currency.
- After that, one can compute the Purchasing Power Parity(PPP) using the formula -
PPP = Cost of good in currency 1 / Cost of good in currency
Compare Purchasing Power Parity In Each Country
[Click Here for Sample Questions]
To make meaningful price comparisons across countries, one needs to consider a broad range of products and services. However, this one on one comparison is hard to acquire due to the insubstantial volume of data that needs to be collected and the complexity of the comparison.
Every periodic year, the World Bank publishes a statement comparing productivity and growth in different countries in PPP and the US dollar. International Monetary Fund and the Organization for Economic Co-operation and Development (OECD) both use PPP metrics for making predictions and suggesting economic policies. Recommended economic policies can have short-term implications for monetary markets.
Some Forex traders use PPP to find currencies that may be overvalued or undervalued. Investors holding stocks and bonds in foreign companies can use the PPP figures in the survey to indicate the effect of exchange rate changes on the country's economy or investment.
Also check: Wheatstone Bridge
Things to Remember
- Purchasing power parity (PPP) is the concept of macroeconomics.
- Purchasing power parity (PPP) lets economists compare nations' economic productivity and living standards.
- It is an indicator used by analysts to compare currencies of different countries.
- It uses the concept of comparing various nations' currencies through a "basket of goods" approach.
- Some countries adjust their gross domestic product (GDP) figures to reflect PPP.
Also Read:
Sample Questions
Ques. Explain Purchasing power parity example between India and the US. An American tourist visits a bakery shop in India. The tourist bought 20 cakes for Rs.350 and saw that cakes are more inexpensive in India. The tourist reasoned that, on average, 20 cakes cost $8 in the US. Calculate the purchasing power parity between the two nations based on the provided information. (3 Marks)
Ans. Given the cost of 20 cakes in INR = â¹ 350
Cost of 20 cupcakes in USD = $8,
Now calculate the Purchasing Power Parity of India with the US by using the formula.
Purchasing power parity = cost of 200 cakes in INR / Cost of 20 cakes in USD
Purchasing power parity = 350/8
Purchasing Power Parity of India with US = Rs.43.75 per dollar
Ques. Explain Purchasing power parity between China and India.In December 2010, a McDonald’s Big burger cost $6.18 in China, while the same Big burger cost was $4.17 in India during the same period. Calculate the purchasing power parity between the two nations based on the provided details. (3 Marks)
Ans. (Exchange rate 1 Chinese Yuan equals 11.88 Indian Rupee)
Given Cost of Big Mac in India = 4.17
Cost of Big Mac in China = 6.18* 11.88= 72.92
Therefore, the purchasing power parity of China with India can be calculated as
Purchasing Power Parity = Cost of Big burger in China / Cost of Big Burger in India.
Purchasing Power Parity = 72.92/4.17
Purchasing Power Parity = 17.48
Purchasing Power Parity of China with India = Chinese Yuan 17.48 per Indian Rupee.
Ques.What is PPP (Purchasing Power Parity)? (3 Marks)
Ans. PPP(Purchasing Power Parity) is a currency conversion rate that balances the purchasing power of various currencies by eliminating differences in price levels between nations. PPP is simply a price relationship, which indicates the ratio of prices in national currency to the same goods or services in different countries. PPP is also calculated for different levels of aggregation up to product group and GDP.
Ques.Which risks reduce purchasing power? (3 Marks)
Ans. Inflation risk is the risk that inflation impairs the return on investment by reducing purchasing power. Bond payments are generally based on fixed interest rates, so they have the highest risk of inflation. In other words, as inflation increases, purchasing power declines.
Ques.What factors affect purchasing power? (3 Marks)
Ans. There are several factors that affect Purchasing power like real income, that is, inflation-adjusted individual income levels. Employment levels and average salary levels have a significant impact on the purchasing power of the economy.
Inflation and deflation, foreign currency exchange, credit availability, price fluctuations due to interest rates also affect purchasing power.
Ques.Why purchasing power parity theory is not used in the short-run? Explain your answer. (3 Marks)
Ans. To hold purchasing power parity prices need to be flexible. In the short run,
prices are not flexible thus PPP is not a good theory for explaining exchange rates
in the short run.Therefore purchasing power parity theory is not used in the short-run.
Ques.How does inflation affect purchasing power? (3 Marks)
Ans. Inflation reduces the value of your money, so you have to spend more on the same goods and services. In other words, as inflation rises, purchasing power declines.
Ques.The quantity theory of money is M/P = L(i)Y. What is the function L(i)? Why is L(i) decreasing in i? (3 Marks)
Ans. Liquidity demand is known as L(i) and it is the share of nominal income that people want to hold as money. Liquidity demand/L(i) is decreasing because money does not earn interest. i is the opportunity cost of money. When i increases, people want to hold less money and more interest bearing assets.
Ques.How does purchasing power affect sustainability? (3 Marks)
Ans. Through its important purchasing power, UN agencies have sustainable developments such as the environment (improvement of carbon, energy and water efficiency), society (reduction of poverty and capacity development), economy (improvement of income and optimization of cost).
Ques.What are the primary uses of PPP? (3 Marks)
Ans. PPP is primarily used as the first step in internationally comparing real gross domestic product (GDP) with its spending factors. GDP is the most commonly used aggregate to show the size of a country's economy and the economic well-being of its inhabitants per capita. The PPP calculation is the first step in the process of translating GDP.
For Latest Updates on Upcoming Board Exams, Click Here: https://t.me/class_10_12_board_updates
Check-Out:
Comments